U.S. Equity And Economic Review: It's A Slowdown, Not A Recession Edition

Includes: RINF, SPY
by: Hale Stewart

By Hale Stewart

Bearish calls on the US economy increased measurably since the first of the year. It's obviously the result of increase market volatility and weaker economic numbers since the first of the year. But a few key stories this week point to data indicating we're not in a recession. While industrial weakness is a primary reason for my recent bearishness, Tim Duy noted that the breadth of weak industrial numbers is very small:

The point is that during a recession, the vast majority of manufacturing industries (or all!) are declining. We are nowhere near that point. In other words, even manufacturing - arguably the most distressed sector of the US economy - is not recession. And if manufacturing is not even in recession, it is difficult to see that the US economy is in recession. Or even nearing it.

Second, the indispensable Scott Grannis posted three articles (see here, here and here) that highlighted various bullish statistics. His posts note the following:

  1. Employment growth is strong
  2. Corporate profits are high
  3. The service sector is still expanding at high rates
  4. The household sector has de-levered
  5. Consumer confidence is increasing
  6. Loans are rising
  7. The housing market - especially construction and new home sales - is strengthening
  8. The slope of the yield curve shows an economy in the middle of an expansion

Finally, see these three post from Invictus at the Big Picture, James Hamilton at Econ Browser and Calculated Risk that further show that we're nowhere near a recession.

That's not to say there isn't genuine cause for concern, however. The latest GDP report showed an anemic .7% Q/Q growth rate. The report contained enough data for bulls and bears. The former will argue the 2.2% Q/Q growth rate in consumer spending is sufficient to propel growth forward while the latter will use the 2.5% decrease in gross private domestic investment to support their argument.

I would argue housing market provides a tie-breaker, weighing the data for the bulls. In the GDP report, residential investment increased a solid 8.1%. On Wednesday, the Census reported new home sales rose 10.8% M/M and 9/8% Y/Y. Not only was this report strong, but the Census upwardly revised previous months: The new home sales report for December was above expectations, and sales for September, October and November were revised up. And there is sufficient demand to pull prices higher: the Case Shiller Index - released on Tuesday - increased 5.83% Y/Y.

Unfortunately, the industrial sector won't be adding to growth anytime soon; new orders for durable goods were disappointing:

New orders for manufactured durable goods in December decreased $12.0 billion or 5.1 percent to $225.4 billion, the U.S. Census Bureau announced today. This decrease, down four of the last five months, followed a 0.5 percent November decrease. Excluding transportation, new orders decreased 1.2 percent. Excluding defense, new orders decreased 2.9 percent.

The following chart from Doug Short places today's report in a broader perspective:

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Core and transportation orders moved sideways since 2012. Orders ex-transportation and defense are the primary reason for increases and decreases over the last four years. The report contained no good news, although some argued it primarily reflected oil and export weakness:

"It's a miserable report across the board," said Brian Jones, a senior U.S. economist at Societe Generale in New York. "It's a reflection of what's going on in industries attached to petroleum and any that are attached to overseas activity - their activity is coming down."

Economic Conclusion: Although various sources (the Atlanta Fed and Moody's) predicted weaker 4Q GDP, the actual report still disappointed. The Q/Q declines in structural and equipment investment made oil sector weakness real while the drop in exports demonstrated the drawbacks of a strong dollar. But while consumer spending growth was lower, it still increased a 2.2% Q/Q and 2.6% Y/Y. And with residential investment up a very solid 8.1% Y/Y, it's difficult to see a recession in the next few quarters. However, with durable goods orders off yet again, we will continue to see industrial sector weakness.

Market overview: The markets are expensive. The current and forward PEs of the SPY and QQQ are 20.93/21.15 and 15.89/17.10, respectively. And fourth-quarter earnings results are weak. From Zacks:

The problematic part on the earnings front is that the aforementioned growth challenge isn't just something in the past; it is very much an issue for the current and coming quarters as well. In fact, all of the earnings growth for 2016 is now entirely expected to come in the back half of the year, with growth in the first half of the year now expected to be in the negative.

Including all of this morning's reports, we now have Q4 results from 173 S&P 500 members that combined account for 43.8% of the index's total market capitalization. Total earnings for these companies are down -1.6% from the same period last year on -1.9% lower revenues, with 72.8% beating EPS estimates and 47.4% coming ahead of revenue estimates. Looking at Q4 as a whole, combining the actual results from the 173 companies that have reported with estimates for the still-to-come 327 index members, total earnings are expected to be down -5.8% on -4.4% lower revenues - the third quarter in a row of earnings declines for the index.

While FactSet.com reports different percentages, they see the same overall picture:

With 40% of the companies in the S&P 500 reporting actual results for Q4 to date, more companies are reporting actual EPS above estimates (72%) compared to the 5-year average, while fewer companies are reporting sales above estimates (50%) relative to the 5-year average. In aggregate, companies are reporting earnings that 1.7% above the estimates. This percentage is below the 5-year average (+4.7%).

The blended (combines actual results for companies that have reported and estimated results for companies yet to report) earnings decline for Q4 2015 is now -5.8%. At the sector level, the Energy and Materials sectors are reporting the largest year over-year decreases in earnings, while the Telecom Services sector is reporting the largest year-over-year increase in earnings.

The blended revenue decline for Q4 2015 is now -3.5%. At the sector level, the Energy and Materials sectors are reporting the largest year-over-year decreases in sales of all ten sectors. On the other hand, the Telecom Services and Health Care sectors are reporting the largest year-over-year increases in sales.

Technically, the market's posture is growing defensive. The two strongest sectors for the last month were consumer staples (up 5.71%) and utilities (up 10.37%). This trend is now in effect for the latest 3-month period:

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And as this relative rotation graph from Stockcharts.com shows, defensive sectors are now outperforming other, more aggressive market segments:

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In conclusion, Martin Pring, one of my favorite analysts, has officially stated we're now at the beginning of a bear market.

"The die is pretty well cast," Pring said. "Virtually every stock market in the world has completed a top. When you get a lot of markets or a lot of sectors doing the same thing - which we call the law of commonality - it's usually followed by a pretty important move. So if everything is breaking down, that's not a good sign on a long-term basis."

Fellow stockcharts.com commentator John Murphy is also bearish. Last year, the SPY couldn't get above the 210-212 price level. After the first of the year, they followed the Chinese market sharply lower. This occurred after several quarters of declining corporate earnings. All things being equal, I, too, am slightly bearish at this point.

Hale Stewart, XE.com