Fall 2012: What's Next?

Includes: DIA, EWSC, QQQ, SPY, VXX
by: Fedor Sannikov, CFA

By Fedor Sannikov

The recent U.S. stock exchange rally set the record in positively closed sessions and set us thinking whether current economic indexes justify the investors' behavior and, more importantly, what comes next? Let us consider the fundamental market growth and earning fixation factors to conclude what can be expected in the last 4 months of 2012.

Below, we will mainly talk about the American market. I will also present our global stock markets movement correlation estimates in breakdown to regional markets. Since the early 90's, correlation tendencies, pointed out by Gerhard, Poon and Khillion in their research works, show that by the end of the 20th century, the correlation between global industries decreases while the correlation between countries grows. At the same time, this does not refer to the U.S. or China markets during the post-recession period since 2009.

Global markets' annual and monthly performance correlation estimates for 2001-2011 are shown below. The figures ranging from 0.85 to 1 are in yellow and from 0.7 to 0.85 are in grey in the global regions annual performance correlation table. The earning correlation figure for the majority of markets exceeds 0.8. In other words, the figures are too high to be beneficial for decreasing risks through standard deviation of performance in long-term investments. The markets of China and Japan, Japan and South Korea, Argentina and China have the lowest correlation figures. The monthly performance correlations are lower which could benefit position traders. The monthly performance correlations between the stock markets of China and other countries remain the lowest.

The regional annual performance correlation:

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The regional monthly performance correlation:

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The author's research shows that under globalization and blurring market borders, creating portfolios with correct choice of industries becomes more relevant compared to the correct choice of regional markets in order to manage international investment risks.

The U.S. Bull Market and Its Causes

1. On the one hand, the latest months have brought abundant data regarding problems in Europe, growth rate reduction in the American and Chinese economies. On the other, such news do not shock investors, they have become used to it, and these risks are accounted for in the price of shares. During the last weeks, the marker participants have been ignoring the negative news while getting excited about the positive, which is a clear sign of a bull market. For how long? It seems that the investors have prepared themselves for the 2% U.S. GDP growth by the 2012 results, and if this "optimistic" forecast proves to come true, there will hardly be huge sales.

The real U.S. GDP growth:

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2. Nonfarm payroll data for July (163,000 growth) exceeded expectations, which inspired the investors especially on the background of weak April-June 2012 data. The number of filed unemployment applications prompts optimism as well (see the graph below). In other words, the unemployment data is not depressing, however Nonfarm payrolls is not the leading indicator.

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By the end of July 2012, labor force in the U.S. was 155 million people. Population growth and labor force at 1% per year in America (without dropping the unemployment rate) means that the U.S. economy should generate additional 1.55 million jobs per year or up to 129 thousand jobs per month. In order to decrease the unemployment rate the number of generated jobs should be significantly higher. Since the beginning of the year, nonfarm Payrolls average growth rate was 151 thousand per month. In order to obtain a 2% and more annual GDP growth, the productivity growth rate should suffice to cover the lack of labor force. In 2012, the 1% productivity growth rate shows that the lack of labor force is covered by the productivity growth.

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3. One of the main fundamental causes for the U.S. stock market growth is the recovery of the real estate market. In the first half of 2012, the average growth rate of building permits was 25.8% compared to the same period last year. The average growth rate in 2011 was 1.2%.

The average Housing Starts growth rate was 27% since the beginning of the year as compared to the same period last year. In 2011 this figure was 5.4%.

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The average rate of new homes sales was 14.9% in the first half year compared to the same period last year. The average growth rate of the index was -3.45% in 2011.

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The average growth rate of existing home sales was 3.5% in the first half of 2012, while this figure was 3.6% in 2011.

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Therefore, the housing market recovery inspires the market participants. The investors believe that construction marker growth would cause the growth of related industries and thus become of the fundamental pillars for healthy economic recovery. Despite the fact that the construction sector employment is only 5.5 million people (which is only 3.6% of the total U.S. labor force), the multiplication effect can become one of the driving forces for further growth. At the same time, construction companies do not rush to hire: the employment rate in the U.S. construction industry has hardly changed since the beginning of 2010 and is far from the 7.5 million people during the pre-crisis period. U.S. construction spending growth is shown on the graph below.

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One of the consequences of the real estate market recovery is that the shares of home construction companies reveal multiple higher-than-expected growths compared to the U.S. broad market index. The graph below represents the comparison between the iShares Dow Jones US Home Construction Index Fund performance and the S&P index performance for the last 12 months.

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4. The bottom line is that people's spending is defined by the income, savings rate and financing are decisive for the U.S. GDP growth. We can make a conclusion based on the graphs below that the average real income growth rate in the first half of 2012 is slightly below 2%. At the same time, the main source of spending - the real disposable income - enjoys a 1% growth rate. This signifies that the population's income grows at the rate of the U.S. residents' increase. There is not income growth per capita (i.e. no "the healthy" life quality increase).

The nominal (not accounting for the inflation) disposable income of the U.S. population exceeds the nominal spending. The average nominal income of the population was $985 billion per month in the first half of 2012 while the average nominal spending was $919 billion.

The savings rate as a percentage from the real disposable income has increased from 3.38% in December 2011 to 4.44% in June 2012. The absolute growth was $137 billion.

We can make a conclusion based on the U.S. real disposable income graph that the consumer credit growth rate was 4.8% in the first half of 2012. The amount of credits increased by $69 billion compared to December 2011. However small, this still is a source of consumer spending.

The population's income and spending figures reflect the past but not the future and this growth is reflected in the prices of shares as of the current date.

The U.S. personal consumption growth:

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The U.S. personal income growth:

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The U.S. real consumer spending growth:

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The U.S. real disposable income growth:

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5. Unfortunately, today the countries' monetary politics can have more influence over the financial markets than the fundamental state of economy. But this only concerns short and mid-term perspective. A speculative cause for the developed markets growth is the expectation that the FRS and the ECB will be able to give their support through the quantitative easing programs when required. In the U.S. more and more FOMC members express their confidence in the necessity of further monetary stimulation.

The latest comments suggest that the FRS is ready to launch QE3 "fairly soon" if the state of the U.S. economy leaves much to be desired. Such expectations allow approaching the risk of investing into shares with more confidence. On the other hand, taking into account almost 0% interest rates, it is doubtful that the QE will have a tangible effect over the American economy. The expectations of the market drug are accounted for in the prices of shares, nevertheless the QE3 amount and the announcement of bond redemption are able to support the stock rates in the short-term.

The Eurozone economy stimulating measures will be discussed at the ECB Monetary Politics Committee meeting in September 2012. The announcement of a new LTRO program is less probable compared to the sovereign bonds redemption program. LTRO demands pledge assets from banks: do they have enough mortgage assets? Securities Market Program will come handy for refinancing Spain and Italy debts and decreasing interest rates for them. Probably, the redemption will begin in the beginning of autumn 2012, and the risks that the ECB will end up containing even more trash assets increase. The growth rate dynamics of the Eurozone residents securities among the ECB assets is presented in the graph below.

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The growth rate reduction in China and the decreasing general inflation open new opportunities to the monetary authorities to broaden the economy stimulating programs, meaning that the Chinese stock market has a chance to perform positively in the second half of 2012, taking into account its relative closeness. The State investments and interest rates reduction did not revive the Chinese economy in the beginning of 2012, while the commodities inflation adds concerns to the government. Did the Chinese government need growth altogether when it had announced the "soft" landing? Investors do not rush to invest into risky emerging market assets. Consequently, the Chinese Shanghai Composite index is renewing its minimums while the American S&P - its maximums.

It is argumentative whether the FRS should implement the quantitative easing on the background of the latest unemployment and housing market reports, though the speculations over the topic continue. Today, this FRS decision is not only economic but political as well: who to support in the election race. Supporting the market before the elections against fair housing market and unemployment rates seems as obvious support of Barack Obama. However, today there is no certainty as to the victory of either candidate, which is why it would be politically correct of the FRS to abstain from any actions until the results of the elections. If, based on preliminary polls Romney's victory is apparent the FRS will be inclined to stimulate the economy.

6. Historically, the years of elections in the USA remunerated those who invested into shares, the summer of the electoral year is considered especially positive. 2012 was not an exception. If we look back, September and October offered sales to the market with further increase and Christmas rally by the end of the year. I expect the stock market to likely perform positively by the 2012 results if Mitt Romney wins the elections.

7. The corporate reporting season also inspire optimism to market participants. The majority of S&P index companies' performances exceeded market expectations in the Q2 of 2012. Above that, in the current economic situation the U.S. market appears as the most attractive from the risk/earnings perspective. The American market has traditionally been considered the safe heaven during stormy times in the Global economy.

Now let's move on to the figures that suggest the coming cooling of the American market.

Bear Signals: Are Sales Inevitable?

1. The Philadelphia Fed Survey, a business conditions index, the leading industrial production dynamics indicator is on the negative side. The Empire State Manufacturing Index reflecting the business conditions forecast for the New York producers also stepped on the negative side in August 2012. Chicago PMI, the leading index of productive and non-productive activity in Chicago, has had a downward trend since the beginning of 2012.

The ISM Manufacturing, a production conditions index, does not only have a downward trend but has closely approached the 50 points limit. When this figure is between 43 and 50 it suggests negative production rates (but not negative rates for economy as a whole). The figure below 43 stands for the beginning of recession in the economy. At the same time, economists joke that the ISM Manufacturing Index has forecasted more recessions than there actually were. A separate graph below shows the comparison of the ISM Manufacturing Index dynamics to that of the S&P.

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Source: Oxenuk Management, LLC.

Source: FRED.

2. The durable goods orders growth rate, the leading indicator of productivity and capital investments, has had a negative trend since the beginning of 2012 (16.11% in December 2011, 7.53% in June 2012). According to Morgan Stanley, 40% of the companies have postponed investing in their development until better times.

The growth rate of the U.S. factory orders, the leading indicator of general production activity, is also decreasing from 11.5% in December 2011 to 2.47% in June 2012.

The business inventory growth rate, the leading indicator of future sales, has dropped from 7.69% in December 2011 to 5.02% in June 2012. I expect low business investment activity until the results of the U.S. Presidential election have been announced.

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3. The sentiment of service industries index has also been downgrading since the beginning of 2012 (56.8 in January; 25.6 in June 2012), although the U. S. ISM Non-Manufacturing Index remains on the positive side.

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The current consumer sentiment is lower than the spring peaks although showing signs of liveliness in June 2012:

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4. In Q2 2012, the current profits of the majority of S&P index companies exceeded expectations. But the profit should be "healthy" proven by the revenue and cash-flow growth. About 60% of the broad U.S. index companies did not meet the revenue growth expectations and are highly conservative in regards to the coming trimesters' forecasts. The cost reduction effect tends to come to an end while sales growth is the long-term source of profit. The graph below suggests the idea that the American corporate profit margin has currently reached its local maximum.

Source: http://www.bea.gov/.

5. "Fiscal Cliff" is another political show gaining popularity in the USA. Compared to the last year's notion of the State debt ceiling it will probably be rotated in the media until the end of the year. The "show" will go on until the end of elections, after which the Congressmen will make a Christmas present to the people and proud of having fulfilled their duties, will retire to celebrate the New Year. If this will not be the case, the Congressional Budget Office presents frightening for the American economy recessional figures which the politicians will hardly agree to. RBK gives the U.S. Congressional Budget Office data: "the fiscal tightening equivalent to almost 4% of the country's GDP will be the most severe since 1969 when the country required funds to finance the Vietnam War. Back then it had led to a recession.

According to the CBO, in 2013 the result will be the same. The GDP will be cut by 0.5%, moreover the economy will drop by almost 3% in the first half year. In a year's time, about 2 million Americans will lose their jobs; therefore the unemployment will increase from the current 8.2% to 9.1%. Based on the CBO estimates, if the Congressmen refuse the fiscal cliff and agree only to minimal cost reduction, the U.S. economy will grow by 1.7% and the unemployment will decrease to 8% next year". Ben Bernanke has already warned everybody that in case of a fiscal cliff the consequences will be dramatic and the FRS will be helpless. The existing uncertainty adds to the market participant's worries, even though such events cannot be called decisive to forecast the market future.

6. The European problems remain though the market has already got "accustomed" to the recession in Europe. The people continue reducing consumption due to various reasons. In the Old World countries, the debt rate per capita is high and the consumption growth is improbable under the stable or dropping real estate prices in the region. The governmental spending reduction means further cut in consumption in Europe, as opposed to America, which mentioned the budget reduction only at the political debates. In reality, we will hardly witness the U.S. state budget deficit of less than $1 trillion in the next 3 years. The exports from China decrease on the background of recession in Europe and the global economy slowing down. This has already influenced the raw material prices as well as those of cyclic and mineral companies.

According to Ru Newspaper, "Athens may lack cash by October without another portion of IMF money and the EU. In such case Athens will be forced to print its own money and Greece will leave the Eurozone. This scenario is not considered as catastrophic by many. Some time ago the Government of Finland confirmed that they have a plan in case of the Eurozone collapses. The Greek economy represents 2% of the Eurozone economy, however opting out of the Eurozone will be a dangerous precedent".

7. The S&P technical index has reached resistance at slightly above 1400 points level. In order to fix the current levels and move on, the macroeconomic statistics should satisfy the optimistic investors' expectations. Moreover, the growth trading volumes are extremely low in August 2012 compared to the average level for the last 50 days.

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8. VIX (Chicago Board Options Exchange Market Volatility Index) has reached its minimum in the last 5 years.

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9. Everything is relative. Is the U.S. stock exchange expensive now? Yes, based on the P/E Schiller's ratio. This ratio also known as Cyclically Adjusted P/E Ratio represents the correlation of the S&P index companies capitalization to the inflation adjust average profit of the index companies for the last 10 years.

10. In conclusion, I would like to present several comparative technical graphs. A healthy stock market index growth means that the less risk-concerned investors will remunerate the small-cap companies. But since the beginning of the year, the S&P500 performance have been more than that of the iShares Russell 2000 Index Fund.

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Even the transportation industry (Dow Jones Transportation Average) closely connected to the economy movement in general lags behind the broad market index.

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A sight into the future is the ground for making investment decisions. Long-term stock market growth is possible under the healthy corporate profits growth proven by the sales and cash flow growth. The leading indicators such as building permits, business and consumers sentiments and new orders rate become primary important from that prospective. Today the leading indicators do not offer a clear-cut picture of the future, while the investors tend to value the U.S. real estate market recovery and the expected monetary stimulation more.

At the same time, we have reasons to believe that healthy corporate profit growth in the nearest trimesters is less probable due to weak business sales growth forecasts. The market has reached an important resistance level by the end of August. Moreover, the investors will tend to sales due to the uncertainty before the elections in November. The possibility of monetary stimulating measures is accounted for in the current market price, although stimulation in Europe and America can support the marker before the U.S. Presidential elections.

I expect sales on the American stock exchange market based on the September and October 2012 results. Further market movement will in many ways be defined by the result of the elections. If Mitt Romney becomes the President the stock market will probably show significant growth by the 2012 results with possible Christmas rally. If Barack Obama is elected, higher market volatility with potential downward movement is probable. At the same time, if Barack Obama is elected President the shares of drug producers and stationed services providers (hospitals) will be in favor in the context of the coming healthcare reform.

If the Congress lingers with voting over the fiscal cliff until the end of 2012, the investors' nervousness may prevent the Christmas rally in case either candidate gets elected President. In case of improbable but dramatic for the market events such as Greece leaving the Eurozone, one should expect higher market volatility with high downward movement potential.

Disclosure: I 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. I have no business relationship with any company whose stock is mentioned in this article.