Economic Outlook Worsens, Stay In Cash

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 |  Includes: SPY, VXX
by: David Frazier

Stock prices in general, as measured by the major stock market indices, traded in a volatile sideways pattern over the past eight weeks, as the readings on some key leading economic indicators worsened while most earnings reports from companies around the globe were better than Wall Street analysts had expected.

Although stocks in most regions of the world rallied from April 24 to May 1, many of those stocks ran into price-resistance levels last Tuesday and then fell sharply on Mary 4 after the U.S. Department of Labor announced that substantially fewer jobs were created during April than most economists had estimated.

With my research indicating that economic conditions will worsen and that the pace of economic growth in most regions of the world will slow during the months ahead, I expect stocks to continue to trend lower during the coming weeks.

The fact that the readings on three out of four of my market-timing indicators recently turned negative, and that the readings on several technical indicators are currently pointing to further stock market declines, seems to support that forecast.

Major Economic Developments

As I mentioned above, my research indicates that the pace of economic growth in most regions of the world will slow during the months ahead. That research is based, primarily, on the most-recent readings on several leading economic indicators, including the following: orders from wholesalers and retailers for durable goods; purchasing managers' expectations of the future demand for manufactured goods; housing market activity; business investments in property, plant, and equipment; the employment situation; and household and business expectations regarding the future direction of the economies in which they reside.

The United States

As you can see from clicking here, new orders for durable goods (i.e. furniture, home appliances, and automobiles) declined sharply in the United States during March, the latest month for which data is currently available, after peaking during December 2011. With sales of automobiles showing signs of topping, my experience suggests that orders for durables goods will likely continue to trend lower over the next couple of months.

Meanwhile, recent readings on producer price indices for industrial commodities indicate that the demand for components used in manufactured goods declined during the past few months.

With inventories at U.S. manufacturers at levels that appear to be sufficient to meet any new orders from wholesalers and retailers of those goods, the factors mentioned above indicate that manufacturing activity in the United States will slow during the months ahead. Any such slowdown would bode poorly for the near-term direction of the U.S. economy and for stock prices in general, as the economy and stock prices tend to move in the same direction as manufacturing activity.

The fact that business investments in property, plant and equipment - in capital goods - have risen much less during the current economic recovery than during any previous recovery since World War II also bodes poorly for the direction of the U.S. economy. That's because those modest investments indicate that business owners and executives think the economy will not improve in a meaningful way during the coming months. As a result of those expectations, businesses are unlikely to make any substantial increases in the sizes of their workforces over the near-term.

Meanwhile, economic statistics for the U.S. housing market indicate that economic activity in that sector of the economy will also slow during the months ahead. For example, the construction of new homes declined during February and March, the latest months for which data is currently available, while sales of both new and previously-owned homes also fell during March. Although building permits for the construction of new homes rose during March, indicating that new home starts likely increased last month, the National Association of Home Builders ("NAHB") announced recently that a fewer number of persons expressed an interest in buying a home during April.

According to the NAHB's chief economist, the declining interest in potential home-buyers is

reflective of the ongoing challenges that are slowing the housing recovery - particularly tight credit conditions for builders and buyers, competition from foreclosures and problems with obtaining accurate appraisals.

Of utmost concern, the employment situation in the United States has already worsened considerably after improving during late-2011 and the first two months of this year. Specifically, the U.S. Department of Labor announced last Friday that only 115,000 new jobs were created in the non-farm sector of the U.S. economy during April, following the creation of only 154,000 new jobs during the pervious month. According to numerous economic studies, that's substantially fewer jobs that need to created every month to keep pace with increases in the size of the U.S. population.

Looking forward, recent reports from several firms that compile information on the jobs market indicate that the employment situation will continue to worsen during the months ahead. For example, the number of new employment advertisements posted on internet web sites declined sharply during April. Meanwhile, global outplacement firm Challenger, Gray & Christmas reported last week that U.S. employers plan to decrease the sizes of the workforces for the fifth consecutive month during May.

Separately, the National Federation of Independent Business, which represents small business owners in the United States, announced during April that a fewer number of small businesses plan to increase the sizes of their workforces over the next few months. That's a very big concern because small businesses account for approximately 65 percent of all new jobs created in the United States.

Lastly, the U.S. Department of Labor reported last week that the four-week average of first-time claims for unemployment benefits, which is a very reliable leading economic indicator, rose during each of the past four weeks.

In the event that the employment situation were to worsen further, there's a good chance that Americans would reduce their purchases of various types of household goods and services. Any such decline in those personal consumption expenditures would likely lead to a decline in the U.S.'s pace of economic growth - in the pace of increase in gross domestic product ("GDP") - because personal consumption expenditures tend to account for approximately 70 percent of the United States' GDP.

China, Brazil and Europe

Although China's economy continued to expand at a fast pace during the first quarter of this year, the pace of economic growth in China slowed for the fifth consecutive quarter during the three months ended March 31, 2012.

Meanwhile, Brazil's pace of economic growth slowed to a year-over-year rate of only 1.4 percent during the fourth quarter of 2011, the latest quarter for which data is currently available. Even worse, economic growth in the Eurozone fell to a year-over-year rate of only 0.7 percent during the fourth quarter of 2011

With purchasing managers at manufacturing companies in those countries expecting manufacturing activity in those regions of the world to decline over the next couple of months, and the overall economic expectations of business executives in those countries falling during the past few months, I expect the pace of economic growth in China and Brazil to continue to slow and for the Eurozone to fall back into a recession during the second quarter of this year.

The fact that the employment situation in Brazil and countries in the Eurozone worsened during the past few months also bodes poorly for the future direction of those countries' economies.

While Brazil's unemployment rate rose for the third consecutive month during March, the latest month for which data is currently available, the Eurozone's unemployment rate rose to 10.9 percent during April after remaining at 10.8 percent during each of the previous three months.

Technical Indicators, Mutual Fund Flows and Near-Term Outlook for Stocks

While the economic developments that I discussed above indicate that stock prices will likely trend lower over the next couple of months, the recent readings on several technical indicators - on indicators that reveal the internal trading action in the financial markets - suggest that stocks are in danger of falling sharply during the second half of this week.

For example, the Chicago Board Options Exchange Volatility Index ("VIX") looks as if it has bottomed and that will move higher during the coming days. Historically, whenever that "fear index" has bottomed and then rose substantially, stock prices in general have fallen sharply.

Meanwhile, the cumulative advance-decline line for stocks that trade on the New York Stock Exchange appears to be forming a double-top and to be in the process of rolling over. Such an occurrence has, historically, preceded major stock market pullbacks.

The fact that the latest readings on State Street Global Markets' Investor Confidence Index indicates that institutional investors reduced their allocation to equity securities over the past several weeks also suggests that stocks are headed lower.

Lastly, the readings on three out of four of my market-timing indicators are currently in negative territory, which also suggest that stocks will continue to move lower during the weeks ahead.

Although the major U.S. stock market indices held above some key price-support levels during the past few days, the technical indicators mentioned above suggest that U.S. stocks will fall sharply in the event that those stock market indices were to fall beneath their respective price-support levels.

With stock market indices for Brazil and India already penetrating some key price-support levels, and price-momentum statistics for the Shanghai Composite Index indicating that Chinese stocks have risen to overbought levels, I expect worldwide stock prices to also move lower during the coming weeks.

Mutual Fund Flows

In addition to the warning signs mentioned above, cash flow statistics for stock mutual funds also bode poorly for the near-term direction of stocks, with individual investors withdrawing money from stock mutual funds during each of the past two months. As a result of those withdrawals, cash allocations at stock mutual funds are currently at historically low levels.

In the event that mutual fund investors were to continue to withdraw money from stock mutual funds, the low cash levels mentioned above might force those funds to reduce their stock holdings. Any such selling pressure would likely lead to further declines in stocks.

Because of the factors and developments discussed in the sections above, I advise investors to get completely out of stocks instead of adhering to the buy-and-hold, or should I say, buy-and-hope advice given by most financial market experts.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.