With QE2 nearing an end, the US economy slowing down, and commodity prices hurting the fragile recovery, the question on every investor’s mind should be “Is the current sell-off a minor correction, or the beginning of something more serious?”
There’s plenty of fundamental information suggesting that equities are attractive, and just as many that show that the economy is rotten and that stocks could crater. So how about listening to the market to assert the situation?
1. Citigroup (C) Economic Surprise Index
This is not exactly market data, but the difference between market expectations and actual corporate profits. Negative readings tells us that investors are disappointed, while positive numbers means that companies are overall beating expectations. We get two important pieces of information form the chart below:
- Extreme negative readings have given good buying points–which makes sense, as when all the disappointing news is out, there’s no more reason to sell.
- We are at levels matched only in November and December 2008, and it appears that this index is bottoming.
This suggests that we are probably reaching the end of the sell-off, and that we are not about to enter a prolonged market decline (notice how in 2008, most of the damage was done while this index was dropping. Investors sell when they get a bad surprise, not after).
(Click charts to enlarge)
The major weakness of this index is the limited historical data. You can get a slightly longer timeframe on Bloomberg, but not that much.
2. Trust in debt markets – Junk Bonds vs Treasuries
This classic ratio would have gotten you out of the market on July 24, 2008; two weeks before things turned really ugly, so it deserves some attention. It is obtained by dividing a high yield corporate bond index (Junk bonds, here I used HYG) by a long term government bond index (TLT). The logic is that when the economy is deteriorating the weakest companies (those paying high interest on their debt) get hurt first, and investors flee to treasuries, driving their yields up.
Recently it has been trending down, as junk bonds took a hit. But the absolute level of this ratio is still comfortably high. We are still far from the “warning level” of the first 2 quarters of 2008, and even further from the “get ready for Armageddon” drop below 0.8 that happened in July 2008.
Overall, I think this indicator tells us that the economy has troubles, but it’s still bearable.
3. Emerging vs Developed
In times of uncertainty, investors tend to take away capital from investments they don’t fully understand–such as foreign investments. In good times, they only see the growth prospects of emerging economies, but when things go bad, they only see the corruption and fraud. I obtained this indicator by dividing the emerging market ETF EEM with SPY.
It has been pretty accurate at calling the major part of the 2008 equity decline, and the subsequent rebound (it suggested to buy in December, not a bad moment).
As you can see it has been rallying of late, suggesting that investors may fear for the US stock market, but not so much for the markets as a whole.
4. Estimating China’s economic health: Copper vs Shanghai composite
China has become an essential part of the global economy, with global companies increasingly relying on demand from its economy to drive their earnings. China’s economy relies massively on construction, of which copper is an essential part. However copper is overall a very minor part of a building’s cost. Therefore, high copper prices do not hurt the construction sector’s profits, but if construction activity slows down, the copper price will crater rapidly.
Since December 2008, the relationship between copper and Chinese stocks has been evolving in an almost perfect channel. That’s the ideal relationship: copper prices increase faster than stock prices, showing a healthy demand for the red metal. Any wild move up (Chinese stocks going down) or down (copper getting hurt) would be worrying.
So despite reports that the Chinese real-estate bubble might be popping, there is still no clear sign of a construction sector breakdown.
I’m sure that everyone will have his or her own way to understand these ratios. My own interpretation is that the overall situation is not rosy, which is why we are in a correction, however it doesn’t seem that we’re about to face a major decline.
We’re entering a ranging, choppy market, so It’s probably dangerous to get short there. Investors would better spend their time finding solid companies that just took a hit.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in HYG over the next 72 hours.