Keep An Eye On This Economic Indicator

Includes: SPY
by: StreetAuthority

By David Sterman

One clear theme that has been in place throughout the second quarter: The broader market should make you cautious, while individual stock bargains abound. I've been hammering home these seemingly contradicting themes, highlighting the need to keep seeking out entry and exit points for the stocks you own and the stocks you are researching.

Well, a just-released economic indicator brings even greater emphasis on the "exit" part of your trading activities. It paints a picture of a tough summer ahead, and as we head into earnings season, and you should be prepared to be taking profits whenever they emerge. (There is a silver lining of this coming period though, as I mention in a moment).

The economic indicator I'm talking about: The Chicago Fed National Activity Index (CFNAI). Four months ago, I noted this was one of three economic indicators I closely track. The index is "a monthly snapshot of the economic growth rate. It gathers 85 inputs, covering virtually every aspect of the U.S. economy and translates it all into one handy number," I wrote then.

In effect, this number portends what the widely tracked quarterly gross domestic product (GDP) reading will look like. In recent months, this figure has steadily weakened, which is why a number of economists say GDP will likely grow less than 2% in the current quarter (a first read on second-quarter GDP will be released on July 27).

Economists say GDP growth will remain muted -- but positive -- for the rest of 2012. If the just-released CFNAI reading for May is any indication, then I'm not so sure. The Chicago Fed notes that the three-month moving average for the index just slumped to -0.34, the worst reading (pdf) since June 2011.

Does this imply we're headed for recession? Perhaps. Economic indicators weakened in the spring and summer of 2011, but eventually snapped back, enabling our economy to keep from moving into negative territory. This time around, however, it's unclear whether we can count on any rebound. That's because Washington's dithering about the coming fiscal cliff has already begun to sap business confidence, according to a few reports.

At this point, you should be concerned that the coming earnings season will be dominated by more cautious outlooks. So even if second-quarter results are solid, then investors may focus on a dire outlook ahead.

The playbook

This is why it's crucial that you remain prepared to book profits on any holdings you have. The market has been gyrating during the past few weeks, posting large gains or losses on any given day. Whenever the market has spiked, you've had a chance to "sell into strength."

Simply put, the S&P 500's move above 1,400 at the end of the first quarter now looks like the high watermark for the year, in my opinion. It would take a remarkable turnaround of current economic trends to justify a fresh rally later this year, which is hard to see right now. So the near-term outlook is challenging as the economy slows, while the mid-term outlook is also sobering due to the fiscal cliff and events in Europe.

The silver lining

Longer-term, there's ample reason for optimism, in large part because companies will likely continue to operate in a very lean fashion, generating solid margins and building cash levels ever higher. In my 20 years following the market, I don't think I've ever seen "corporate America" look quite so solid. U.S. companies are extremely well-positioned to play leading roles in the global economy -- when it gets healthier.

So even as I think profit-taking is the prudent stance for this current market, I also think we are seeing stunning values emerge -- if you are a long-term investor. That's why I don't want to own any stocks that are richly-valued based on near-term operating strength. Instead, I want to own stocks that are deeply undervalued in the context of where the U.S. economy will be as we move into the middle of the decade. This means banks, industrials, commodities, housing and other beaten-down sectors (or at least any stocks that have been crushed within these sectors). It's no coincidence that my $100,000 Real-Money Portfolio owns stocks like Ford (NYSE: F), Citigroup (NYSE: C), Alcoa (NYSE: AA) and Freeport McMoran (NYSE: FCX). These are well-run companies with bright long-term futures and discounted near-term valuations.

Risks to Consider: Upside risks? They're hard to spot. A resolution to the crisis in Europe would help avoid further global economic downdrafts. And if Washington miraculously got its act together and enacted bipartisan solutions to our current fiscal mess, then global investors would pour into the U.S. market. Also, the Chinese government is now stimulating its economy, which could provide a sharp lift to commodity stocks in coming months.

You only score big multi-year gains when stocks are hated, as was the case in late 2008 and early 2009. We're not quite there yet, which is why I think this is a good time to raise cash. But if the CFNAI reading is indeed a harbinger of even lower GDP forecasts to come, then we will likely see the market fall to levels that we used to call a once-in-a-generation buying opportunity (which sadly comes a lot more frequently these days).

Disclosure: David Sterman does not personally hold positions in any securities mentioned in this article. StreetAuthority LLC owns shares of F, C, AA, FCX in one or more if its “real money” portfolios.

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