- Tapering is beginning to take its toll. The leap in mortgage rates is a more rational explanation for the slowdown than the weather.
- Could it be simply that the path to normalization has begun in earnest?
- It's blatantly obvious that a portion of the excess liquidity has found its way into parts of the market - reflected in the tech mini-bubble.
Most of the economic data we've been seeing (don't forget it's historical data) belies the common thinking that the weather has been dampening economic growth. The just reported U.S. GDP revision for the 4th quarter (up from 2.4% to 2.6%) suggests things might not have been so bad after all. Was it reasonable to expect a carbon copy of the 4.1% GDP growth experienced in the 3rdQ of last year? Of course not.
It seems bad weather didn't stop consumers from having their strongest shopping spree in three years.
I find the current consensus disturbing, namely that inclement weather is responsible for the slowing of the economy, and when the weather improves there will be a huge resurgence in economic activity.
Behavioral scientists have published a great deal of research suggesting that we people have certain flaws in our thinking. One that seems to impact the financial markets is our tendency to accept simple explanations readily, because we're too lazy to delve into causes and effects that are complex. Monetary stimulus has been easy, employment has been improving - judging by the recent decline in jobless claims - and industrial production has improved. So why is there so much worry concerning stock markets? It must be the weather.
(click to enlarge)There are more fundamental forces at work. The softness in the housing market is being shrugged off (it's the weather!) but in the U.S. housing and related services account for a significant percent of GDP growth. Tapering is beginning to take its toll. The leap in mortgage rates is a more rational explanation for the slowdown. Despite the deluge of fairly positive data releases telling us it's been pretty good, it's developments like we're seeing in housing that normally would suggest things will be not-so-good very soon.
Another flaw in our thinking is assigning too much weight to recent experience. This is why most folks are demonstrably bad when it comes to managing their investments. Because the stock market has done well, there are many who believe that it should continue to do well. They believe this even though there's no rational reason to believe it. It is this flaw that causes humans to continue to make the same mistakes - such as buying at market tops and refusing to buy during slumps - over and over again.
An even better indication that the market (perhaps because the economy really is under pressure, and not because of the weather) is about to suffer a setback is the high level of consumer confidence. I've indicated in the past that consumer confidence is a contrarian indicator. Note in the following chart how markets perennially peak in springtime (usually in April or May). Consumer confidence seems to peak about the same time. What almost always follows is commonly expressed as "sell in May and go away!"
Someone might argue that this is too short a time period to be reliable, but rest assured I've been a money manager for decades and the pattern just won't quit. The recent strong consumer confidence measure bodes ill for the stock market, just as the slump in housing is not good news for the economy near-term. The weather is sure to improve, but don't expect much sunshine from the economy or financial markets over the coming months.
Are we and the stock market in denial? Talk of a 'double-dip' recession seemed to grow quieter once the correction I predicted back in January ran its course and the market headed to new highs. I still adhere to my expectation for a strong year, but needless to say decades of experience has taught me the ride will always be a bumpy one.
This chart sums up what where we've been and what we still have to contend with for the next several months.
(click to enlarge)It is quite probable that post-Bernanke, Janet Yellen believes her real "job" is to orchestrate a return to normality. This necessarily will mean some pain for gain. The yield curve shift from upward sloping in 2005 (more or less normal) to the ugly line corresponding to 2007 (see chart) was a sign of imminent doom - we could all agree at the time. Downward sloping yield curves imply deflation and ultimately worse. Quantitative easing and the 'twist' managed to massage down rates into the somewhat deformed 2012 yield curve depicted above - a scenario we've since grown too accustomed to. The current dilemma is that today's yield curve is looking even more bizarre. Mid to long rates have been rising while the short end remains ridiculously low.
(click to enlarge)Stepping back for a moment, I used this chart (courtesy of TD Securities) quite a long time ago to anticipate what had to happen in due course. Somehow the 10-year Treasury yield had to rise or the forward earnings yield on the S&P fall so the relationship stabilized - and I suggested both would happen.
Since then the earnings yield indeed declined as stock prices rallied (hence my bullish view of equities at that juncture) and long rates did rise if not dramatically (hence my bearish stance on bonds back then).
But what about NOW? There still is a surplus of liquidity at the short end out there by almost every measure I've seen. Although consumers did 'bite' and borrow large as they were supposed to - to get the economy rolling - in response to lower rates; the banking and corporate sectors did not. As tapering continues, the issue is whether liquidity will shift into the longer end (higher margins for lenders) which would be ideal, or will a slowing of the economy serve to stifle lending; forcing longer rates down again. In other words, will the few dollars actively investing out there just switch from stocks back to bonds while the cash horde continues to sit on the sidelines and constrain growth? Seems very likely based on the sudden 'risk-off' sentiment brewing.
All signs point to a global slowdown: China's sudden decline in exports and a downward revision to their economy's growth rate, coupled with a stalling of Europe's recovery creating anxiety. Could it be simply that the path to normalization has begun in earnest? What might 'normal' look like?
There are many opinions about the inflation outlook, but 'normal' critically depends on this parameter. If we believe that inflation can remain at 2% or less (rather than hitting levels of 3.5% to 4% like in 2005) then a 10-year yield hovering at around 3% to 3.5% would not be outrageous. To me this means that the earnings yield on the S&P 500 still has room to continue to decline (i.e. stock prices can go even higher eventually).
The only real uncertainty in the short term is whether China's newfound fiscal discipline and Europe's struggles will impact corporate profitability on a global scale. The answer is yes. Why then has this not been discounted in the stock market? Why have valuations, as many articles published of late insist, continued to stay lofty?
Perhaps we and the stock market in simply in denial? Yes, and it has to do with the behavioral factors outlined above. Short rates will in due course rise and create stress, following the pattern we're seeing in the mortgage market.
It's blatantly obvious that a portion of the excess liquidity has found its way into parts of the market desperately trying to get some sort of return - reflected in the mini-bubble (not my expression but I read it somewhere and it fits) of technology-related growth situations and real estate. Evidence? Takeovers in at high premiums using abundant cash (a bearish sign) in a small segment of the market; and margin debt at frightening levels.
The good news is that operating income on Main Street U.S.A. seems to be holding its own. Less sensational acquisitions in many other sectors abound at reasonable takeover multiples - usually a good indicator that the broader economy still has legs. Therefore I remain convinced that the stickiness of liquidity in the short end of the yield curve will begin to slowly but surely find a home in the longer end of the yield curve and that the new Chairman of the FED will get things back on course in due course. For those wishing to avoid getting caught in the mini-bubble, it's simply time to seek shelter from the storm.
Seasonality (sell in May and go away) combined with a deterioration in profitability and economic growth - however short-lived - will any day now spook a stock market in denial. Bonds as an alternate are fine, but don't expect more than the coupon in terms of return and be prepared to lighten up once short rates move higher in earnest.
The ideal place to be invested when short term rates do rise, in I short term securities. Once the correction has run its course then forget about biotechnology and internet plays. It will be time to bet on those sectors that haven't rallied as aggressively; namely industrial and basic materials stocks (even gold). It will be clear soon that China's economy has bottomed and the smart money will begin scrambling to be leveraged to that country's rebound.
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. I have no business relationship with any company whose stock is mentioned in this article.