by Thomas J Smith, CFA
There are some conflicting signs being thrown at us right now. There has been a risk off trade in the U.S. stock market. Several of the more speculative high flyers that led the market higher have seen heavy selling over the past few weeks. Perhaps this is a sign of spreading weakness in the market or just a rotation into names that represent a better value.
Last week we saw the industrial sector move out to new highs. This is a positive sign for the market. These names are often leading indicators. If they experience buying pressure that is a sign that the outlook for the makers of heavy equipment and other big picture items could see strong earnings releases going forward.
Let's look at some of the recent economic releases to attempt to gain some insight into how the industrial economy will do in the coming months. If you look at the regional leading economic indicators for March, the numbers are quite strong. The regional numbers are as strong as they have been since the early part of 2011. We got off to a great start in 2011 only to see a very sharp pullback in the spring. That pullback was a reflection of a surge in commodity prices due to higher rates of growth in the emerging markets than we are currently seeing.
Over the next few months, we will see if there is an increase in risk or if investors reduce risk in their portfolios, causing a retreat in the market. The data over the past few months has improved dramatically. We have seen numbers recover from what was reported earlier in the year when we experienced some of the worst winter weather on record. The first gauge we have seen improve is the economic surprise index. The LEIs have, by and large, been better than expected so the surprise index has improved. In March, 10 of the 13 leading indicators we track were in positive territory.
Will this trend continue? While I don't have a crystal ball to tell me the answer, perhaps we can use a tool to help us make this assessment. Over the past six months, the prices paid component of the regional indicators have been declining. As input costs go down, the potential profit from moving those goods through the system improves. With prices paid decreasing for the past six months, we are now seeing an uptick in the regional indicators.
One factor that has led to the falling input costs is weakness in the emerging markets. As growth slows in China and other emerging markets, there is less pressure placed on a variety of input costs. If the trend in costs continues to decrease, we could very well see a continued increase in the numbers released in the regional indicators.
Decreased demand from the emerging markets has a tremendous impact on growth prospects in our economy. The lack of inflation due to emerging market demand has a positive impact on regional LEIs and ultimately company profit margins. Non-inflationary growth is a foreign concept to many because we have not seen it since the 1990s. One of the major catalysts for strong performance last year was the lack of inflationary pressure on input costs. During a time of lower inflation, growth can remain strong and P/E ratios can continue to expand. If we do see continued strength in the LEIs that will eventually have a positive impact on quarterly earnings.
There was a rally early last week that was met with an aggressive sell off to conclude the week. There was a rotation away from the aggressive high flyers that were in favor to more traditional larger cap names. This is not surprising given the recent run higher in speculative issues. The rotation was aggressive at the end of last week, but it is not surprising to see names with huge runs see profit taking.
Short-term support for the S&P 500/Dow/NASDAQ/Russell 2000 are: 1838/16,130/4100/1145. More important intermediate-term support levels are: 1830/16,040/4033/1125.