Are Economic Data Ringing The Bell At The Top?

|
Includes: BBEPQ, CLX, COP, DUK, LNGG, MEMP, WM
by: Ted Waller

Summary

Economic measures around the world are at points often associated with recession.

Equity markets eventually follow economic conditions.

Pre-emptive investment strategies for the current environment are provided.

166 years ago Thomas Carlyle was the first person to refer to economics as "the dismal science." Originally the term was earned by dismal conclusions about the human condition developed by Thomas Malthus and other economic thinkers. Today, it also refers to the bewildering and competing array of theories that economists expound, none of which seem to explain things to our satisfaction.

To their credit, economists mostly operate in an objective, empirical world, and therein lies value. While their record of prediction may not be good, they help understand the past and can provide a relatively clear picture of what's going on in the present.

The Present Economic Picture

When we look at the economic present, a very unsettling picture has developed. Many metrics are at points most often found around a recession. Many of these are familiar to SA readers, and while any single measure may not be significant so many are converging in the same direction the trend cannot be ignored. To wit:

  1. Collapse in commodity prices. Not only oil, but coal, iron, copper, and many other commodities are at multi-year lows. Many producers are struggling with prices below the cost of production.
  2. Low interest rates. Low rates are generally seen as an indication of low demand for capital and a sign of low or no growth.
  3. Yield curve inversion. Long term yields have come way down and the curve is flatter than it has been for a long time. What would the true curve be without the heavy hand of central banks holding down the short end?
  4. Yield spreads. When capital markets become concerned about the economy, they move money from riskier to safer fixed income. Yield spreads have been consistently going higher from historically low levels.
  5. High unemployment. Yes, the headline unemployment number in the U.S. has been coming down. However, the lower participation rate and workweek length reduce the significance of that number. In any case, employment is a lagging indicator, not a leading one. In much of the world unemployment is already at recession levels.
  6. Deflation. The trend towards deflation is accelerating around much of the globe, with the Eurozone showing actual deflation in its latest report.
  7. Low wage growth. In the U.S. low wage growth has been one of several disappointing aspects of the recovery.

It's possible to give a non-recessionary explanation to some of these phenomena. Perhaps low oil prices are mainly the result of action by one country - Saudi Arabia. Perhaps low copper prices are simply coming from Chinese hedge funds. What is important is that all seven are consistent with recession and all seven are in place now.

Bright spots not so bright?

Looking further around the current economic environment, there are precious few signs that the world is in expansion rather than recession. The World Bank predicts world growth for 2015 at 3%, but their estimates are dropping and are notoriously over-optimistic. China's 2015 growth forecast is now 7.1%, but that is acknowledged to be a politically inspired number and on a downward trajectory.

The brightest spot for investors is the U.S. stock market, generally considered to be a forward-looking measure. It would be prudent, however, not to confuse the size of one's portfolio with general economic conditions. As we look beyond our shores the U.S. market is becoming increasingly uncoupled from the rest of the world and, as we learned in 2008, decoupling is a dangerous concept to rely on.

Instead, more anti-growth factors are arising. QE has been seen a support to low bond spreads and high stock prices, and since its end in early December (the program ended in October but it took a number of weeks to end purchases) the stock market has had a new lack of momentum.

The energy boom that was supposed to drive an American economic renaissance is sputtering. Now it's being said that low oil prices will be a boon for the economy. Well, which is it? We know for sure that energy companies are slashing capital investment in the sector ($820 million by Linn Energy (LINE) alone!), earnings will be lower, and capital funding is drying up from low stock prices and higher borrowing rates.

Beyond economics

Beyond economics, there are signs that investor behavior is already changing. The defensive utilities sector has become very popular. After an amazing 26% gain in 2014, the trailing PE is 21.7, surpassing the S&P PE of 19.9. Volatility as measured by the CBOE Volatility Index (VIX) averaged 14 for most of 2014 but is now above 20. Market leadership is becoming increasingly narrow, with barely 50% of NSYE stocks above their 200 day moving average.

Investment implications

Behind the euphoria in the media about an improving economy, higher stock prices, and the wildly successful "buy the dips" strategy there is an increasing accumulation of economic and behavioral signs that all is not well. Together they send a strong message that the world is heading towards recession in 2015. At present, the economic metrics discussed in this article don't constitute a sell signal, but for this author they are enough to indicate new equity purchases should be postponed. Even in the energy sector there is still a lot of air under seeming bargains like Memorial (NASDAQ:MEMP) and Breitburn Energy Partners L.P. (BBEP), as well as larger companies like Conoco Phillips (NYSE:COP) that have held up relatively well so far. Early fourth quarter earnings reports will signal if it is time to consider taking profits, particularly in companies that are still leading the market such as Duke Energy (NYSE:DUK), Waste Management (NYSE:WM), and Clorox (NYSE:CLX). If a recession comes to pass, few if any equities will be spared from a decline. Cash could turn out to be one of the most rewarding assets for 2015.

Final thoughts

Everyone has a plan for how they would react to a significant market decline. By paying attention to economic signals we have an opportunity for pre-emptive, rather than reactive, action. Whether one has a long or short investment horizon, much better opportunities to put money to work should be available later this year. Patience, always a valuable investor trait, will be especially important in this increasingly unsettled environment.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.