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Summary

  • The financial liquidity spigot is being squeezed, which is bearish
  • Recession risk remains remote, which is bullish
  • Recent changes at the margin suggest bulls may be gaining upper hand

Investing is a lot like poker. You need to know when to hold and when to fold based on the cards you are dealt. When you have a great hand and the odds are in your favor, you press your bets and are more aggressive with your investments. There are other times when you are dealt a lousy hand and it is best to play it conservative and fold.

Similarly, there are various environments that the financial markets deal us that are more conducive for having strong convictions in our allocations to the market and there are times when the environmental conditions favor a much more cautionary stance. Essentially, there are times to focus on the return ON your money and other times to focus on the return OF your money.

In the game of investment poker it is important to know who you are playing against. While some, through decades of experience, have developed a knack for determining the market's tell (a change in behavior that reveals the market's hand or next move) and can remain in the game with a weak set of cards (uncertain market conditions), most of us need a dose of humility to know we are not smarter than the market and shouldn't press forward with weak hands. For the past month or so we've clearly been dealt a weak hand with a large number of conflicting signals arising in the market.

However, markets live on the margin and recent improvements like the NASDAQ reclaiming its 50-day moving average, a decline in credit default swaps on junk bonds, and new highs in the S&P 500 suggest the bulls' hand may be turning for the better. Given strengthening economic data and how weak the case is for recession (as I show below), I believe the bulls should still be given the benefit of the doubt.

Financial Liquidity Spigot Is Losing Pressure - Reflected in Most Speculative Areas of the Market

There is a reason why the general mood in the markets has been sour. For starters, the average stock in the NASDAQ and the small cap Russell 2000 index are in bear market territory with -26.57% and -22.98% declines off their 52-week highs. We are talking about thousands of stocks on U.S. exchanges that have experienced a bear market, and yet more notable indexes like the Dow and the S&P 500 are trading around all-time highs. Clearly markets have been weaker than what headline indexes would appear to be conveying.

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Source: Bloomberg
(As of 05/23/14)

A notable development that has been suggesting caution is the liquidity hose losing pressure. One source of liquidity over the past year and a half has been the yen-carry trade which has helped fuel the U.S. stock market higher. When the yen began to be devalued in the fall of 2012, the pressure behind the yen-carry trade was beginning to mount and needed and a release valve. That valve appeared to be the U.S. stock market once we had our debt ceiling and sequester debates behind us at the start of 2013. Throughout last year, moves in the yen tended to give an early warning of trend changes in the U.S. stock market and of concern was the divergence between the yen and the S&P 500 at the start of the year. While the yen and the S&P 500 are diverging, the yen and the average stock in the NASDAQ and Russell 2000 are not, as both are heading in the same direction. Given the relationship between the yen and the U.S. stock market, moves in the yen should be monitored ahead for any potential changes in global liquidity.

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Source: Bloomberg

Another watch point that needs to be monitored in terms of liquidity is the loss in the velocity of margin debt in the U.S. Stock market returns are greatest when the rate of change in margin debt is expanding and run into trouble when margin debt growth slows. Another characteristic we see in margin debt is when the annual rate of change jumps north of 50%, which is often a sign of euphoric animal spirits at bull market tops. This is seen below looking at margin debt growth alongside the S&P 500 highlighted by the blue arrows.

What I want to highlight are periods in which the S&P 500 rallied while margin debt slowed, which is shown by the red shaded boxes below. The first example led up to the 1987 crash, the second occurred in 2004, and the third is the present case which began in the middle of 2013. In both the 1986-1987 and the 2004 cases, margin debt growth peaked just as the Fed began to raise interest rates and the cost of margin began to rise. We saw a crash in the 1987 case and in 2004 we were treated to roughly a 9% decline in the S&P 500. In the present case, while the Fed is not raising interest rates they are pulling back on the QE throttle which is akin to monetary tightening by letting off the accelerator a bit, though not actually hitting the brakes. The decline in margin debt growth began in mid-2013 when the word "taper" entered the U.S. financial lexicon.

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Source: Bloomberg

The deceleration in margin credit in 2004 led to a correction/consolidation and it appears that 2014 is not likely to provide the returns we saw last year. Without the benefit of strong momentum, stock picking and risk management should carry higher importance.

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Source: Bloomberg

Recession Risk Remains Low

While it appears the liquidity spigot appears to be closing, that doesn't mean the bears should be emboldened to press their bets. As highlighted in the margin comments above, the deceleration in margin debt could merely be a case of investors anticipating an eventual rate hike as they did in 2004 and there was no bear market, just more volatility and weaker stock market returns.

Additionally, the risk of recession remains quite low and if anything the economy is accelerating out a weak Q1. On Thursday we were treated to the release of the Conference Board's Leading Economic Index for April that showed another monthly increase as the index rallied to a new cycle high. This is significant as the index peaks well in advance of a coming recession and often peaks before the S&P 500 does, serving as a leading indicator for both the market and the economy. This can be seen looking at the last 15 years, which shows the index serving as an early warning to the 2001 recession and bear market as well as the 2007-2009 recession and bear market.

5
Source: Bloomberg

Another great indicator from the Conference Board is their Employment Trends Index (ETI) which does a great job in providing a 3-5 month lead time for real GDP growth. We can see that the ETI's growth rate is comfortably above 0% and suggests that Real GDP should remain in expansionary territory well into 2014.

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Source: Bloomberg

This is good news for the stock market as the ETI and the S&P 500 are highly correlated and, given the ETI has far less fluctuations than the S&P 500 does, it serves as a great filter of market noise and commentary that moves to hysterics the moment the market shows any weakness. The continued advance in this index provides a bullish argument for the stock market.

7
Source: Bloomberg

Another positive development comes from the Philadelphia Fed's State Coincident Diffusion Index which shows that 90% of U.S. states are showing economic expansion. It's when the number of states in expansion and contraction are 50/50 (coinciding with a diffusion reading of 0%) that we should worry about a recession as shown below. The zero line often serves to bookend recession start and end dates and the fact we are at 90% should provide plenty of comfort to the bulls.

8
Source: Bloomberg

Another key indicator is the Chicago Fed's National Activity Index (CFNAI), which is a weighted average of 85 monthly indicators of national economic activity that measure four broad categories: production and income; labor; personal consumption and housing; and sales, orders, and inventories (manufacturing data). A positive reading suggests growth above trend while a negative reading suggests growth below trend. Historically, a -0.70 reading tends to serve as bookends for recessions and so our current reading of 0.19 suggests we are growing above trend and well above recessionary thresholds. Recessions are shown below by the red shaded regions.

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Source: Bloomberg

Also encouraging is our own recession probability model which suggests only a 9% chance the U.S. is in or near a recession. I usually look for readings north of 20% as a major warning indicator.

10
Source: Bloomberg

As I often mention, the two main causes of bear markets are a recession and/or a financial crisis. As highlighted above, the risk of a recession is remote as is the risk of a brewing financial crisis. One indicator I use to measure the health of the credit system is the Ted Spread. Shown below you can see that when the Ted Spread begins to rise that often marks financial unrest and the formation of a top. You can see the spikes in the spread prior to the 2000 and 2007 bear markets and of note is the very benign reading currently that suggests all is well in the credit system.

11
Source: Bloomberg

One last quick note about liquidity; while we are seeing financial market liquidity slow from the yen-carry trade and margin credit, we are seeing greater liquidity through more traditional measures such as bank lending which tends to support the economy more so than financial markets. This can be seen when looking at core bank lending growth, which shows the highest quarterly growth rate (top panel below) in years as core bank loans outstanding (bottom panel) hit a new cycle high.

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Source: Bloomberg

Another potential source of liquidity for the bulls is their nemesis, the bears. Short interest on the NYSE is at the highest level since 2011 and 2012, and has the potential to add fuel to the market should a short-squeeze occur in the markets. Whenever short interest on the NYSE rolls over we tend to see strong stock market returns. Recently the NYSE short interest level has begun to contract, which indicates the bears are starting to cover. Should short interest levels continue to decline we may see new highs in the market as we did during the 2009, 2010, 2011, 2012 declines (see blue arrows) that fueled higher stock markets.

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Source: Bloomberg

Currently, what is perhaps the most encouraging change at the margin is that the NASDAQ (black line below) reclaimed its 50-day moving average and credit default swaps on junk bonds (high yield) declined significantly this week (red line, shown inverted below), breaking their bearish trends in place since March. It is always a welcome sign when the riskiest areas of the market stabilize, with improvement in the NASDAQ and junk bonds suggesting the tug-of-war between the bulls and bears may have finally been decided in the bulls favor.

credit default swaps
Source: Bloomberg

Summary

There are times to be agnostic towards the market and not beholden to either the bull or bear camp. This often occurs when investors are dealt a weak hand with a large number of conflicting signals. It is probably best for both the bears and the bulls to go easy until the weight of the evidence leans more strongly to either camp. The bears have a loss in financial liquidity to support their case while the bulls have solid economic data and strengthening bank liquidity at their backs.

Given the riskiest areas of the market like the Russell 2000 small cap index and the NASDAQ have shown the greatest declines with the loss in financial liquidity, should these areas show further stabilization and then advance that would suggest the bulls are gaining the upper hand. Given the NASDAQ has reclaimed its 50-day moving average and the S&P 500 closed above 1900 for the first time (while credit default swaps on junk bonds improved significantly this week as well) it appears risk appetites are building again. Will the bears be forced to cover their shorts and head back to their caves? We shall see.

Source: Recent Changes At The Margin Suggest Bulls May Be Gaining Ground