Unpleasant Times Ahead For Stocks

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Includes: DIA, IWM, QQQ, SPY, TLT, UUP
by: Leo Nelissen

Summary

Leading indicators show further downside for the economy and stock markets.

Growth slowing is turning into a contraction.

Stocks are facing tremendous risks from the economy and illiquid markets .

The title of this article is extremely bearish. I don't want to scare you but warn you about what might be coming.

Back in December I wrote an article mentioning the RISK OFF sentiment and warning for a correction. Stocks did indeed go down and fueled the discussion if a bottom has been reached. In this article I want to go a step further and discuss a few important fundamental changes and give you my view for the coming months ahead.

I want to start with the most important leading indicator for the US economy and stocks. The ISM Manufacturing Index which is released every month by the Institute for Supply Management.

The ISM printed its first decline at a below 50 level since the recession back in 2008 and is falling towards 48. The possibility of a contracting ISM index increased during the growth slowing trend which started around August 2014. A declining ISM index indicates increasing recession probabilities as well as lower stock prices. An ISM print below 49 further increases the probabilities of an even lower ISM index.

If you compare the ISM index with regional surveys conducted by for example the Dallas and New York FED, further downward pressure is clearly visible. In all fairness it must be said that regional surveys are way more volatile and cover just a 'small' part of the US economy. However the sharp decline in oil prices is becomes clearly visible in the Dallas FED survey.

I use the regional surveys mainly because they are reported at least a week before the official ISM data is made public.

Both surveys point to a lower ISM. It is nearly impossible to say what the next release will be but the odds point to a lower ISM.

An argument often used by optimists is that the US economy is not highly depending on manufacturing but mainly on services. That is a true statement if you look at the GDP distribution but not valid when it comes to the strength of the economy. Manufacturing is way more important because it has by far the highest multiplier of all sectors, has the highest productivity growth rate and pays good wages. Furthermore is has diversified employment and is a source of innovation. And last but not least manufacturing is critical to other value-added sectors in the economy. If you want to read more about this click here.

The following chart shows that the service economy is starting to slow too. The effect of a slow down is becoming clearly visible in the NMI index which is also published by the Institute for Supply Management.

The fact that both leading indicators (ISM & NMI) are cooling down should be visible in coincident indicators like retail sales and industrial production. These indicators either confirm or disprove the leading indicator outcome. Over all coincident indicators confirm the outlook given by leading indicators.

A closer look at the picture above shows that the growth rates of both retail sales and industrial production are weakening. The growth peak has been reached in 2010 with a graduate decline until mid-2014 after which the decline accelerated and even resulted in industrial contraction. This perfectly reflects the ISM and NMI data.

Stocks are not ignoring the economic slow down. As seen below multiple sectors are already in a bear market. First it started with energy and transportation followed by basic materials and home builders. The chart was made by Kai Pflughaupt. I highly recommend following him on Twitter if you are interested in global macro.

For me it is also important to mention the risk coming from high yield and commodity related companies. Companies all over the world were able to lend astronomically high amounts of money due to near-zero interest rates. Especially oil related companies invested this money in production facilities and ended up with a tremendous overproduction.

Now add the fact that commodity prices are near multi year lows and you get a perfect storm. Companies placed leveraged bets on a high production rate in the future by lending money and investing it in production facilities as mentioned above. Since the price of commodities (especially oil) began to fall their investments began to weight on the oil company's balance sheets sending bond prices to multi-year lows.

The chart below shows the bond yields for CCC and lower rated companies. Many of them are energy related companies.

With commodity prices at these low levels and a FED that started hiking rates, the pressure keeps growing. The likelihood of a massive global debt default for energy companies is enormous. That would also effect non-commodity related companies since so much is depending on the energy sector resulting in a further downturn of the economy.

This would be the REAL deleveraging cycle central bankers and politicians have been talking about.

The 'only' problem is that this would put further pressure on the economy and crash stocks worldwide.

Furthermore since banks are not allowed to do proprietary trading (Dodd Frank) the liquidity needed to prevent steep sell-offs is gone.

To conclude this article I want to make sure that you are careful. This time is definitely not different. Regardless of what so called 'professionals' on TV will tell you. The market is due to an even further sell-off. Investments in bonds like iShares 20+ Year Bonds TLT or long USD Proshares DB US Dollar Index UUP are appropriate for the long term.

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.