Over the past few months, I've written several articles recommending that readers cut positions in the overall market, in particular the S&P 500 (NYSEARCA:SPY). You see, we have witnessed a few historic conditions, which simply stated, warrant caution or outright bearishness on behalf of investors. Let's run through a few of the major catalysts unfolding before our eyes.
The Federal Reserve
The Federal Reserve's decision to raise interest rates was both widely discussed and monitored. Many writers, analysts, and fund managers spent a great deal of time speculating on when rates would increase and to what extent. To my shock however, very few analysts asked a simple question with profound implications for investment decisions: "What happens when rates actually increase?" You see, when the Federal Reserve increases interest rates, it sets off a chain reaction of economic events with strong implications for the world economy.
One of the rates which the Federal Reserve manipulates is called this discount rate. This rate is used around the entire world by companies of all stripes and flavors as a benchmark rate. This benchmark rate is used in return calculations to determine if projects or investments meet an adequate threshold for pursuit. If a project provides an attractive enough return when accounting for risk, companies spend capital to make investments. When the Federal Reserve increased rates, it tightened the difference between what firms are able to borrow at and the return on a typical project. This means that firms will be pursuing fewer projects, hiring less workers, and doing overall less investment. In other words, the economy is slowing down. Don't take my word for it - here's a chart of the current manufacturer's new orders.
As you can see - we are in a slowdown. For the past several months, orders have been in the strongest pullback since the recession of 2008-2009. This has profound implications for the entire economy - as interest rates continue to increase, fewer orders will be filled as firms pursue fewer projects.
"Who cares? Isn't the stock market separate than the economy - aren't they weakly correlated," you say. Alas, this is not correct. The stock market is correlated to economic indicators, you just have to do a little work to find the correlations. The market never rewards simple thinking.
As you can see, there is a pretty strong correlation between the trend of manufacturing and the S&P 500. In fact, declines in manufacturing have led or coincided with every major decline in the S&P 500 for the past 22 years. Considering we are currently in one of the largest pullbacks ever in manufacturing orders, doesn't it make sense to stay short the S&P 500?
Simply said, the Federal Reserve's actions will slow economic activity - this is inevitable. The relationship between the rates manipulated by the Fed and the economic is pretty clear and logical. As the Fed squeezes rates, the economy slows, and stocks tend to decline. It really doesn't make very much sense to be long the S&P 500 until manufacturing recovers and the economy rebounds. My recommendation is to stay short or out of the market until we see a 12-month positive percent change in manufacturing - then we will know the economy has adjusted and we're out of the slump.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.