U.S. Equity And Economic Review: Grinding Growth And A Weaker Market, Edition

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Includes: AIRR, DIA, FIDU, FXR, IYJ, QQQ, RGI, SIJ, SPY, UXI, VIS, XLI
by: Hale Stewart

Once again, the LEIs and CEIs are split; the LEIs decreased .2% while the CEIs increased .3%:

4/10 LEIs decreased while one was unchanged. In contrast, all the CEIs increased - even industrial production, which, for the last five months, subtracted from growth. This combination of weaker LEIs but slightly stronger CEIs leads to the following conclusion:

The Conference Board LEI for the U.S. declined for the second month. As a result its six-month growth rate has moderated further and is considerably slower compared to six months ago. Meanwhile, The Conference Board CEI for the U.S. has been rising through January, and its six-month growth rate has been relatively steady. Taken together, the current behavior of the composite indexes and their components suggest that the expansion in economic activity should continue in the near term, but the pace of growth will remain modest.

The Fed released their latest Meeting Minutes which contained the following observations of various GDP components:

  1. Employment growth is strong
  2. Industrial production weakened in the 4Q
  3. PCEs were slower, but
    1. Income was increasing, and
    2. Sentiment was positive
  4. Housing was positive and
  5. Business investment was weaker than desired

Most important were the several paragraphs the Fed spent on financial market turbulence:

Domestic financial conditions tightened over the intermeeting period, as turmoil in Chinese financial markets and lower oil prices contributed to concerns about prospects for global economic growth and a pullback from risky assets. The increased reluctance to hold risky assets was associated with a sharp decline in equity prices and a notable widening in risk spreads on corporate bonds. Treasury yields declined across maturities, reflecting a downward revision in the expected path of the federal funds rate and likely some increase in safe-haven demands amid the market turbulence. The dollar appreciated against most foreign currencies.

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Broad U.S. equity price indexes declined sharply over the intermeeting period, exhibiting a high correlation with movements in crude oil prices and foreign equity indexes. Domestic equity indexes were quite volatile in January, and one-month-ahead option-implied volatility on the S&P 500 index climbed to the upper end of its range of the past few years. Spreads on corporate bonds over comparable-maturity Treasury securities widened over the intermeeting period, reportedly reflecting increased concerns about corporate credit quality, particularly in the energy sector, and a decline in investors' willingness to assume risk.

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Global financial market conditions deteriorated sharply in January, as recent developments in Chinese financial markets and the further decrease in crude oil prices appeared to increase concerns about global economic growth. Equity prices in emerging market economies (EMEs) and in advanced foreign economies (AFEs) fell sharply, and 10-year sovereign yields in the AFEs decreased substantially. Market expectations for the policy rates of major foreign central banks, which had risen somewhat after the December FOMC meeting, ended the period lower. Credit spreads in the EMEs widened. The foreign exchange value of the U.S. dollar appreciated further against most currencies, with larger increases relative to the currencies of commodity-exporting countries.

While the Fed reviews the financial situation in every meeting, here, the Fed devotes a significant amount of editorial space to the magnitude of recent market events. Yellen made a similar observation during her recent Congressional testimony. The inclusion of international events in both documents serves a very important purpose: the Fed is publicly acknowledging that they are not only aware of recent turmoil, but are including it in their analysis and may alter their interest rate course accordingly.

Other US news was positive. Industrial production - one of four coincident indicators and the one causing weakness in the CEIs for the last year - rose .9%. And a detailed analysis of industrial production sub-indexes indicates weakness is contained. Building permits - a very important leading indicator - decreased, but only by .2%. And they were up 13.5% Y/Y. Finally, housing starts declined modestly (3.8%).

The Atlanta Fed's GDPNow predicts 1Q growth of 2.6%; Moody's high-frequency number is 1.2% and the Cleveland Fed's interest rate forecasts 1.9% growth. Meanwhile, the Cleveland Fed's recession forecast is 6.19%; the Atlanta Fed's recession model is 10% and the New York Fed's interest rate prediction is 4.56%.

Economic Conclusion: While the slight weakness in the LEIs is concerning, the breadth of the slowdown is currently contained to the industrial sector. And this month's industrial production rebound provides a welcome boost to the CEIs. While this week's housing indicators were slightly lower, that can easily be attributed to monthly statistical noise. And with mortgage rates dropping, there is little reason to see a meaningful slowdown in this sector.

Market Summary: the market remains expensive. The current and forward PEs for the SPYs and QQQs are 21.82/20.55 and 15.75/17.01, respectively. And the earnings outlook - along with 1Q16 projections - remains weak. From Zacks:

Including all of this morning's reports, we now have Q4 results from 402 S&P 500 members that combined account for 86.4% of the index's total market capitalization. Total earnings for these companies are down -6.4% from the same period last year on -4.7% lower revenues, with 68.2% beating EPS estimates and 47.6% coming ahead of revenue estimates.

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Estimates for 2016 Q1 are coming down on a daily basis as companies report Q4 results and offer a soft outlook for the current period. Total earnings for the S&P 500 index in 2016 Q1 are currently expected to be down -8.0% from the same period last year, which is down from an expected decline of -1.1% at the start of the period. While most of the negative revisions to Q1 estimates reflect developments in the oil patch, estimates for other sectors are coming down as well, with earnings for the index on an ex-Energy basis now expected to be negative as well.

The averages reflect this weakness. Let's start by looking at the Russell 2000:

At the end of last year, prices couldn't stay above the 200-day EMA, leading to the end-of-the-year sell-off. Since mid-January, the indexed traded between 95-102. Prices are about 10% below the 200-day EMA. Technically, the picture is weak. Both the 50 and 200-day EMA are moving lower and momentum, while improving, is negative.

Let's move up the market cap scale and look at the mid-caps:

The same analysis applies.

Assuming small and mid-caps would rally first and more aggressively on solid news, the above charts indicate that, should we have great economic news, the indexes are moving upstream. Let's place that information into the broader context of the weekly SPYs chart:

The primary issue on the SPY's weekly chart is the gently weakening technical picture. Prices are slowly moving lower, with the obvious price target of either the top Fibonacci raw or 200-week EMA. Momentum and relative strength are declining and market breadth is weak.

These charts point to a market that will most likely move lower.

Hale Stewart, XE.com