Daily State Of The Markets: Are You Worried About The Economy Yet?

Includes: DIA, IWM, QQQ, SPY
by: David Moenning

When the corrective phase the stock market finds itself mired in began it was all about China. China's currency. China's economy. And China's stock market. Then the focus changed to oil. And for some time now traders have tied their buy and sell algos to the price of oil. But we all know this too will end at some point as Wall Street tends to have the attention span of a gnat - and the focus can quickly change.

While I don't think that traders are ready to abandon the oil/stocks correlation trade, a couple of other issues have cropped up lately that could easily become the next big thing. First there is the subject of the banks, which we have already discussed this week. The bottom line here is that we need to continue to keep a very close eye on the action in names in the U.S. like Citigroup (NYSE: C), Morgan Stanley (NYSE: MS), and Bank of America (NYSE: BAC) as well as some big banks across the pond such as Deutsche Bank (NYSE: DB) and Credit Suisse (NYSE:CS).

However, another issue that seems to be garnering an awful lot of attention lately is the issue of the "R Word" here in the good 'ol USofA.

To anyone paying attention to the data, talk of a recession in the U.S. seemed rather silly a month or so ago. However, as the global economy has slowed, so too has the economy here at home. And while the odds of the U.S. tipping into recession are not high at this time, they have moved up a bit recently.

Manufacturing Is Weakening, But...

There is no denying the fact that the manufacturing sector of the economy has weakened significantly over the past six months. And it is fairly easy to argue that this sector of the economy is already in recession.

The good news has been that manufacturing is not a large portion of the U.S. economy. No, it is the combination of the consumer and the government that is responsible for the majority of economic growth, with the consumer responsible for something on the order of 70% of GDP.

Up until very recently, the argument could be made that the consumer is doing just fine, thank you. And as such, the idea of the U.S. slipping into recession was viewed as folly. However, one thing we've learned is that news travels fast these days as most folks digest the news of the day on their phones and data is instant. Thus, the consumer has shown a propensity to "stop on a dime" from an economic perspective when a crisis (or something that might become a crisis) arises.

So, it was a bit disconcerting to see the ISM Non-Manufacturing index (an indicator that measures the state of the services sector of the economy) crater this week. While the index remained in positive territory, meaning that the sector is still growing, the index fell much more than had been expected, has declined in five of the last six months, and fell by the largest amount in more than a year.

In addition, the business activity sub-index sank 5.6 points, which was the biggest decline since November 2008 and the employment component tanked 4.2 points to the lowest level in more than a year.

So... While none of this data suggests that the economy is heading into recession, it is safe to say that things are slowing a bit. And since the stock market is a discounting mechanism of the future, the argument can be made that at least part of the recent downside volatility might be attributable to the idea that the economy is weakening.

Should We Worry?

I know, I know; I appear to be doing my Debbie Downer routine again this morning. But actually I'm not. You see, I've set you up - there is actually some very good news to report here.

Ned Davis Research has a model for just about everything under the sun. And one of the models I follow on a daily basis is their Economic Composite. This is a model of models that is designed to provide an objective reading on the "state" of the economy.

The bad news is that this model reading has fallen a fair amount recently, moving from a reading of 80 last month down to just 48.9 this week. This took the model rating from moderately positive to neutral.

I know what you're thinking... "Uh oh, that can't be good!" But, this is where the fun begins.

You see, according to NDR's computers, the S&P 500 has gained ground at an annualized rate of +10.1% per since 1965 when the Economic Composite is in the moderately positive zone. However, when the model reading is rated neutral - as it is now - the S&P gains at a rate of... wait for it... +10.5% per year! (Insert smiley face emoticon here.)

While it may sound strange, this is likely due to the lagging nature of economic data. Usually, by the time the economic indicators become weak enough to move the model, the stock market has likely already corrected. And then when a recession doesn't materialize, stocks tend to celebrate and move up in advance of the model improving.

Now, if the model slips further and moves into the moderately negative or negative zone, it is a different story entirely as the S&P has lost ground at a rate of -8.5% and -23.0% respectively. But the good news is that the model would need to drop a fair amount from here in order to reach the moderately negative zone.

The Bottom Line

So... As long as whatever we are currently dealing with doesn't get nasty (meaning the U.S. avoids a recession), history suggests that the dips in the stock market should be bought.

However, if the banks in places like Italy, Spain, Portugal, or even China, begin to take on water and the spillover starts to infect the U.S. banks, well, then all bets are off. Remember, the big, bad declines in stocks tend to be associated with threats to the global banking system. But again, this does not appear to be the case at the present time.

Therefore, the current plan is to continue to watch the price action of the major indices closely. Currently, it looks like the bulls are trying to get a rebound going. But of course that can change quickly, right?

So for now, the bottom line is that we need to remain alert - and flexible. From my perch, it looks like break below 1860 is a problem and a move above 1950 is positive - at least from a near-term perspective.

Turning to This Morning

It has been an uneventful session so far as it appears traders are simply waiting on the jobs report to be released at 8:30am eastern before making any meaningful moves. The consensus expectation is for nonfarm payrolls to increase by 190K in January and for the unemployment rate to remain unchanged at 5.0%. Oil is slightly higher in the early going and futures currently point to a flat open on Wall Street. However, this is likely to change with the release of the jobs numbers.

Today's Pre-Game Indicators

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

Major Foreign Markets:

Japan: -1.32%

Hong Kong: +0.55%

Shanghai: -0.65%

London: +0.46%

Germany: -0.15%

France: +0.48%

Italy: +0.53%

Spain: +1.22%

Crude Oil Futures: +$0.37 to $32.09

Gold: +$2.20 at $1159.70

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

10-Year Bond Yield: Currently trading at 1.848%

Stock Indices in U.S. (relative to fair value):

S&P 500: -0.50

Dow Jones Industrial Average: +14

NASDAQ Composite: -0.20

Thought For The Day:

Regardless of the colors on the screens, you can make the decision to enjoy your day.

Current Market Drivers

We strive to identify the driving forces behind the market action on a daily basis. The thinking is that if we can both identify and understand why stocks are doing what they are doing on a short-term basis; we are not likely to be surprised/blind-sided by a big move. Listed below are what we believe to be the driving forces of the current market (Listed in order of importance).

1. The State of the Oil Crisis

2. The State of Global Central Bank Policy

3. The State of China's Renminbi

4. The State of the Stock Market Valuations

The State of the Trend

We believe it is important to analyze the market using multiple time-frames. We define short-term as 3 days to 3 weeks, intermediate-term as 3 weeks to 6 months, and long-term as 6 months or more. Below are our current ratings of the three primary trends:

Short-Term Trend: Moderately Positive

(Chart below is S&P 500 daily over past 1 month)

Intermediate-Term Trend: Negative

(Chart below is S&P 500 daily over past 6 months)

Long-Term Trend: Moderately Negative

(Chart below is S&P 500 daily over past 2 years)

Key Technical Areas:

Traders as well as computerized algorithms are generally keenly aware of the important technical levels on the charts from a short-term basis. Below are the levels we deem important to watch today:

  • Key Near-Term Support Zone(s) for S&P 500: 1870
  • Key Near-Term Resistance Zone(s): 1950

The State of the Tape

Momentum indicators are designed to tell us about the technical health of a trend - I.E. if there is any "oomph" behind the move. Below are a handful of our favorite indicators relating to the market's "mo"...

  • Trend and Breadth Confirmation Indicator (Short-Term): Negative
  • Price Thrust Indicator: Negative
  • Volume Thrust Indicator(NASDAQ): Neutral
  • Breadth Thrust Indicator (NASDAQ): Neutral
  • Short-Term Volume Relationship: Neutral
  • Technical Health of 100+ Industry Groups: Negative

The Early Warning Indicators

Markets travel in cycles. Thus we must constantly be on the lookout for changes in the direction of the trend. Looking at market sentiment and the overbought/sold conditions can provide "early warning signs" that a trend change may be near.

  • S&P 500 Overbought/Oversold Conditions:

    - Short-Term: Moderately Overbought

    - Intermediate-Term: Oversold

  • Market Sentiment: Our primary sentiment model is Neutral

The State of the Market Environment

One of the keys to long-term success in the stock market is stay in tune with the market's "big picture" environment in terms of risk versus reward.

  • Weekly Market Environment Model Reading: Negative