In previous articles I've been laying out the case that long term valuations for the stock market are historically high, which generally means a leveraged financial system. A leverage financial system generally means an economy that is fragile, susceptible to shocks, and prone to recessions. As equity markets closed lower in August and have entered September, historically the worst month for the stock market, the question being pondered by investors: is this the normal summer doldrums or are we headed towards another recession?
In my previous article I wrote that I was expecting the economic data to start coming in weaker than expected because the ISM cycle looks like: 1) it is peaking 2) it is now in a cyclical decline. The ISM data has continued to come in weak so let’s see where we’re at in the cycle.
Inventory stuffing: the first thing that I would note is that inventories have been built out to the highest level since 1984. This puts negative pressure on the manufacturing chain; why would executives order more goods if their inventories are already at a 20 year high? Clearly manufacturing executives were expecting a normal recover and have stocked their shelves accordingly to their expectations. Unfortunately by most standards, other than maybe stock market performances, this recovery has been exceptionally soft and it's hard to see consumption picking up substantially when unemployment remains at stubbornly high 9%. ISM inventories have been cyclically peaking and troughing with the economy, and there is a lot of room before the next cycle low. If the ISM cycle has indeed peaked we could be looking at disappointing manufacturing reports for many more months, if not years, since troughs seem to be about 3 to 6 years apart.
GDP continues to come in weak (with backward revisions lower), especially when compared to previous post recession recoveries. Some continue to fall back on corporate profits but seem to ignore that: 1) profit margins are a mean reverting statistic (and appear to be at a major peak) and 2) profits more or less peak with the stock market (they not forward looking). Therefore, profits and profit margins at historically high levels, if anything, is predictive of a future decline, rather than a continued rise.
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Looking at the year-over-year change in real GDP, we are towing the line at 2%. Since records began in 1947, every recession has been prefaced with a drop below the 2% real GDP YOY mark. While the majority seems to be counting on a pick up in the last quarter and early 2012, as I've pointed out with the ISM inventory cycle, a substantial pick up in manufacturing does not seem likely.
The Economic Cycle Research Institute, Weekly Leading Index
Several months ago the ECRI weekly leading indicator made financial media waves as it started flirting with -10, a level that has previously predicted looming recessions. While nearly every analyst immediately took to the airwaves to discount the ECRI, one thing can now be said with certainty: at minimum it has correctly predicted economic weakness. Let’s take a look at where the ECRI currently stands.
The ECRI weekly leading index is once again falling into negative territory, and is currently at -4.3. Furthermore there is a huge bearish divergence between the previous and most recent peak. The Dow on the other hand has risen about 3,000 points from the previous corresponding peak in the ECRI. The ECRI's most recent peak shows that this rise in equities was achieved and deteriorating underlying economic fundamentals. Lastly, I would note that similar divergences occurred preceding both the tops in 2000 and 2007. This may be argumentative to some, what cannot be argued is that the number is: 1) negative 2) falling and 3) very unusual considering we just came out of a recession.
The Possibility of Stimulus
I think it should also be noted that if we are entering another recession that monetary and fiscal policy tools have been somewhat exhausted, and the possibility of further stimulus if greatly reduced. On the fiscal side we recently saw the US Government engage in an extremely partisan battle regarding the debt ceiling. If the economy does start to falter, it seems very unlikely that policy makers will be able to come together and react in time to stimulate the economy. Historically policy makers typically don't respond until markets are already crashing (think how TARP was rejected on the first vote). It would probably take a much weaker economy, thus much more public outcry, before Government will be sufficiently motivated to react.
On the monetary side, rates are already at near zero. While some argue that "the Bernake" can always print more money, recall that during the last Fed meeting we saw several dissenting votes. These were not votes against the possibility of QE3, these were dissenting votes on just keeping rates low, and some regional Fed presidents have began openly questioning the effectiveness of QE2. In retrospect, the economy is still week, unemployment is still high, the stock market has come back to levels when QE2 started. So other than a rise in commodity prices which has hurt consumers, exactly how has QE2 been a success?
The Stock Market
The Long Term Bull/Bear Trend Model is flirting with price levels that would confirm a bear market. Last month's performance is already a red flag and if the SPY closes below 120 by the end of September, the model suggests stocks are in a confirmed Bear Market. As of this writing, stocks are already below that level.
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We are also seeing some other classical technical analysis red flags:
- The 50 day moving average is now below the 200 day moving average, a signal many long term managers take into consideration when deciding how they position client portfolios.
- The RSI has had a long running bearish divergence and has now registered it's first break of the 30 handle since the March 2009 low, in a bull market the RSI should respect the 30 handle.
- The trend line connecting the lows since the March 2009 bottom has been broken on both arithmetic and logarithmic scale charts.
Cash Levels at Mutual Funds (Update)
The stock market is basically an auction process, so available cash is a key ingredient for bidding prices higher. For the last several months I've been warning that cash at mutual funds was near a record low. Well, that is no longer true, because now they at a new all time record low.
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So despite the recent gyrations, mutual fund managers remain very long this market and very short of cash on hand. If the markets continue to decline, redemptions could very well trigger a long squeeze.
The ongoing flow of economic data seems to have turned, or substantial slowed at best. To be towing the line between growth and contraction is simply unprecedented considering the recession supposedly just ended, and the extraordinary amounts of stimulus and lose monetary policy that have been enacted. Simply put, the economy should be roaring, instead, it's just barely chugging along. While the stock market hasn't produce a long term sell signal just yet, it is throwing up enough red flags that equity investors should take note.
Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in SPY over the next 72 hours.