Daily State Of The Markets: Goldilocks Vs. The Three Bears

Includes: DIA, SPY
by: David Moenning

While the situation in Cyprus will likely dominate the market on this fine Monday morning, I have decided to step back across the pond and focus on the macroeconomic forces as it relates to the stock market here at home in this morning's missive.

While I tend to ramble on at times in this space, I think I can sum up the current situation in the U.S. stock market with the following: Goldilocks vs. The Three Bears. I know what you're thinking. He isn't really going to do an analogy of the age-old fairy tale, is he? To set your mind at ease and to encourage you to continue reading, the answer is no.

My message this morning revolves around the idea that the market is enjoying a "Goldilocks" type of environment from an economic standpoint at the present time. The economy isn't "too hot" so as to produce concerns about inflation, which would force the Fed to change horses in the middle of the race. And yet at the same time, the economy isn't "too cold" enough to cause any real concerns about the U.S. slipping back into recession. So, with the Fed keeping rates low, no real inflation concerns, record earnings, fair valuations and an economy that is improving, the bulls would seem to have the edge right now from a big-picture standpoint.

I know that the bears would have you believe that we are a missed EU deadline away from the U.S. economy stopping on a dime and sliding into recession. However, in light of the fact that we review every single important piece of economic data that is released in real time around here, I can tell you that this concept is sheer folly right now. The U.S. economy is "doing just fine, thank you" at the present time and barring another crisis/shock/tsunami, should continue to improve over time.

And what if I am just seeing things the way I want to, you ask? Since this is always a possibility in this business, I spend a bunch of money on independent research each year. The idea is to "farm out" the key analysis of data to people who make their livings getting these types of things right more often than not. And over the years I've learned that while nobody gets it right all the time, you should ignore or disagree with the major theme coming from some firms at your own peril.

One firm in particular has developed a nifty group of indicators it calls its Recession Probability Model. The idea is to combine the nonfarm payrolls, average manufacturing hours worked, the unemployment rate, real wages, and real salaries of each state in the U.S. and them lump them all together. The result is an indicator that has correctly called the recessions and recoveries in the U.S. on a timely basis. And since the NBER (National Bureau of Economic Research -- the official keeper of U.S. recessions and expansions) doesn't ever confirm that the country is actually in or has exited a recession until well after the fact, having an indicator that can give us a clue about the state of the economy in real time is helpful.

The Recession Probability Model called the recession of 1979/1980 the very month in began. Then in mid-1981, the model's signal came one month before the actual recession started. In 1990, the signal occurred within two months of the beginning of the recession (which was triggered by the first Gulf War and as such, can be considered an event-based recession). In 2001, the indicator gave us a heads up one month into the actual recession. And finally, the model told us that the economy was sinking six months into 2008. And although this can be considered a bit late, remember that nobody knew for sure that the economy was in recession until early 2009 after the stock market had fallen more than 50%. And knowing that the U.S. was in recession in June of 2008 would have helped save investors an awful lot of money as the S&P was around 1400 when the signal was given (for the record the ultimate low of the S&P 500 during the 2008-09 bear market was around 667).

To be fair, the model was "wrong" in 2002-03 as the economy never actually re-entered a recession. But staying out of stocks based on the indicator wouldn't have been a bad idea. And then there was a very brief misfire in mid-2009 where the indicator flashed a warning for one month and then quickly retreated. But overall, the model has done a great job of managing economic/stock market risk over the last 33 years.

So, what is the indicator saying now? Although the data is only updated monthly, the probability of recession at the present time is 0.5% based on the stats from all 50 states.

However, there is an awful lot of talk right now about the economy's "green shoots" that are appearing right now turning into "withering roots" again. You see, for the last three years, the early economic improvement that has been seen in the U.S. has been interrupted by some sort of crisis. As such, more than a few of those seeing the economic glass as half empty are betting on a "four-peat" to occur.

To review briefly, there have been three brushes with the bears since the recession ended in 2008. In 2010, it was our first encounter with Greece that hit stocks hard. Then in 2011 it was the combination of Europe/Greece and the U.S. budget battle. And then last year, it was once again the situation in Europe that caused the bears to growl a couple of times. Thus, those who have missed the boat on the early rally this year are licking their chops over the possibility of another mid-year correction.

So, should we expect our "Goldilocks" economy to succumb to the bears once again this year? Should we look to "sell in May and go away" yet again? Most of the "fast money" types say yes. After all, Wall Streeters love their historical trends. But my thinking is that unless (a) the Recession Probability Model issues a warning or (b) there is another external shock, those bears looking for a severe correction (>10%) might go wanting this year. But as a reminder, when it comes to actual money management decisions, we will ignore my musings and stick to what our models are saying on a daily/weekly basis.

Turning to This Morning...

The majority of foreign markets as well as the U.S. stock futures are higher this morning on the back of the last-minute deal to avert a banking collapse in Cyprus. In case you haven't seen the reports, Cyprus reached an agreement with the troika Sunday evening to receive 10 billion euros for the county's banking recapitalization plan. While markets are breathing a sigh of relief, the bears remain fervent that the sky will fall across the pond at some point in the future. Helping fuel this view, Moody's said that the Cyprus deal was a negative for the sovereign debt ratings of the countries in the EU. The question of the day, of course, is how long the rally will last as the S&P approaches its all-time high at 1565.15.

Pre-Game Indicators

Here are the Pre-Market indicators we review each morning before the opening bell:

Major Foreign Markets:

  • Shanghai: -0.05%
  • Hong Kong: +0.61%
  • Japan: +1.68%
  • France: +1.48%
  • Germany: +1.20%
  • Italy: -0.02%
  • Spain: +1.16%
  • London: +0.94%

Crude Oil Futures: +$0.49 to $94.20

Gold: -$6.10 to $1,600.00

Dollar: lower against the yen and euro, higher vs. pound

10-Year Bond Yield: currently trading at 1.963%

Stock Futures Ahead of Open in U.S. (relative to fair value):

  • S&P 500: +8.21
  • Dow Jones Industrial Average: +65
  • Nasdaq Composite: +15.49

Thought For The Day...

To think is easy. To act is hard. But the hardest thing in the world is to act in accordance with your thinking. -- Johann von Goethe

Positions in stocks mentioned: none.