I recently published an article for fellow Alpha Seekers suggesting an impending increase in volatility for U.S. equities, the importance of QE to the U.S. economic recovery, how uneasy some members of the FOMC might become as a result, and how it was likely that the Fed would contemplate a tapering of asset purchases earlier than most market participants expected.
The recently released Fed minutes certainly held up to this assessment, and it has given the market some jitters.
New information since then also raises the question of where next for U.S. equities: continue, consolidate, correct or crash?
The graph below shows where the S&P500 is relative to forecast:
Source: Own forecast based on market available data.
If the U.S. recovery is speeding up, it could be the case that the market is front-running the forecast, which needs to be revised upwards, and expecting a crash or correction would be a mistake at this point.
On the other hand, if the U.S. recovery were to stall, it increases the chances of a sell-off in U.S. equities.
Bearing in mind that all organizations missed the -0.1% GDP growth for the last quarter, could the economy be heading downhill and no one tracking the obvious?
The key recent evidence supporting the accelerating growth hypothesis has been the higher than expected corporate earnings; reduced trade deficit, some outstanding December housing start data and falling jobless claim figures.
The key evidence pointing to slowing growth rates is that some tax increases have been implemented, government spending is paring back, there is policy uncertainty, transportation volumes are down and negative growth amongst overseas trade partners will eventually hit U.S. shores.
And there was the negative manufacturing print on the Philly PMI, but positive order print. Leading indicators continue to give mixed pictures of roughly "below trend" moderate improvements to U.S. GDP.
The evidence I review below is directly related to economic growth, which remains the main driver of stock market performance:
Employee Gross Earnings and Personal Disposable Income
As the graph shows, both real employee earnings and real personal disposable income (PDI) have risen since the beginning of 2010.
In the last 2 months, PDI has even accelerated sharply, while employee earnings remain on trend. However, the reason for PDI and earnings to have jumped has been the anticipation of tax rises, which meant pre-tax bonus rewards were brought forward. The PDI surge is unlikely to be repeated, but in fact, could be reversed.
Furthermore, this extra disposable income did not fund increased consumption spending (and did not boost company sales figures and will not boost GDP); households instead shored up their savings in the face of greater uncertainty in 2013. With higher taxes on the way, the effects on gross employee earnings are uncertain.
Interestingly, it is very possible that the surge in PDI at the end of last year has been the source of the recent cash boost to equities and fueled the "great rotation has begun" stories. Also, the boost to savings explains why households appear "more comfortable" or "less concerned" about 2013 than 2012; both effects being transitory.
The graph below shows trend values for other key components of GDP growth:
Data Source: US Bureau of Economic Affairs.
While Consumption (C, the main component of GDP) is back above where it was in 2006, it has not recovered back to be growing at as fast a pace as before the recession. Compared to the previous graph, the path followed by C has largely matched the red arrows: slower growth in the aftermath of the financial crisis.
In fact, PCE has grown at a slightly slower rate than personal disposable income, as households have sought to repair balance sheets. The most recent data suggests this is continuing and in the face of uncertainty, increases. Furthermore, as tax increases bite and reduce PDI even further, we are likely to see a fall-off in consumption, or at least a flattening of PCE for the next quarter or perhaps two, as households adjust. Some corporate results are already indicating the impact is being felt in this earnings season.
Government expenditures (G) are falling, with a sharper dip at the end of 2012 in anticipation of the fiscal cliff, which did not materialize. The downward trend in government spending is set to continue, and the rate of that drop depends on whether a grand bargain is struck, a sequester hits or there is more can-kicking. Can-kicking could well lead to anticipatory government spending cuts or discretionary project spend being put on hold.
The other main category is investment spending (I). This, as the graph shows, remains the category significantly below par, and in the last quarter, was stalling once again.
The trend also suggests that whatever investment made since the financial crisis has been made wisely. Income growth and demand for more output has been met with lower levels of investment and employment: i.e., significant productivity gains.
Arguably, the productivity gains remain the main source of the impressive corporate profitability performance since the recovery began and have underpinned equity valuations. In other words, the gains from the recovery have been channeled into equity holders' pockets and cash onto company balance sheets, rather than being matched by growth in employee earnings.
As a result of productivity gains as well, the recovery in employment is at a slower pace, with fewer people in employment now than in 2006.
Finally, orders are holding up. However, orders will get affected by increased uncertainty, reduced personal disposable incomes and falling government expenditures, along with any trimming back of investment expenditures as the main components of Aggregate demand slow their growth or go into decline.
The virtuous circle of more orders leading to the creation of more goods and services to provide higher employment and better investment opportunities leading to higher incomes leading to more spending and more orders -- remains on a barely upward trajectory, but firmly below pre-crisis norms.
Furthermore, pending factors already point to a significant slow down in the rate of GDP growth for 2013 compared to the main forecasts around. It is even likely that 2013 Q1 will have a negative print to GDP, with some recovery in the second half.
The danger with negative prints to GDP is that it can trigger further recessions. And also further policy interventions.
Implications For Trading Strategies
New economic information, as it comes in, is pointing to an increasingly large correction for equities in the cards, with increasing likelihood of it happening.
My central view remains that the most likely level to which the S&P500 will correct is around 1400.
The market has repeatedly demonstrated, however, that what matters for short-term trading is the Fed response. If the market believes a slowdown to recovery will be big enough for the Fed to step up its program of asset purchases, then any correction will be brief, and perversely, there may well be a positive reaction to bad news (2012 Déjà vu trading strategies).
If on the other hand, the market believes the Fed will be reluctant to do more, a correction will be significant.
On this issue, I currently hold the opinion that the Fed's response at present is extremely aggressive in the history of monetary policy, and it will be reluctant to dramatically change course until enough evidence is marshaled on the effectiveness of its existing policies and will increasingly focus on only two economic parameters: inflation and unemployment. This view, of course, may change in the light of new information.
The only thing regarding the future of which we can be certain is that we will change our view of it.
1. The forecasting method and accuracy has been explained in this previous article
2. Some notable current forecasts of U.S. Real GDP growth in 2013 are as follows (listed in order of most recently made to less recently made)
- Conference Board : 1.6%;
- US government: (CBO) 1.4%;
- US Fed: 2.3% to 3.0%
- Goldman Sachs: 1.5 to 2.5%
- OECD: 2.2%