April 13th, 2015
by Lance Roberts, StreetTalk Live
Over the last couple of weeks, I have been writing heavily about the numerous warnings signs that are suggesting that the current spate of economic weakness may be more than just a soft patch. (See here, here, and here)
The importance of the deterioration in earnings and economic data in the short-term is being offset by hopes that the first quarter sluggishness was simply a weather related event.
However, as I discussed last week, there may be more to that story.
"If you have been reading my blog for very long, you will already know that I have argued precisely against the common meme as espoused in Josh's article. In the post-financial crisis world:
- Employment figures are an obfuscation caused by a structural shift in employment and a shrinkage of the active labor force.
- Cheap gasoline does NOT power consumer spending.
- Falling unemployment does not boost wages which there is a large available labor pool.
- Inorganic economic growth does not lead to higher incomes
With the stock market having doubled in price from its 2009 nadir, it is certainly understandable why Josh and many others would be lost as to the divergence between statistically driven headlines and economic realities.
However, the real danger is coming from the Federal Reserve, which is considering tightening monetary policy by raising rates sometime this year. But the real question is why?
The Federal Reserve tries to control economic growth, and subsequently inflation, by tightening or loosening monetary policy. When an economy is growing too quickly, the Federal Reserve raises interest rates to slow economic growth to prevent inflationary pressures from accelerating too quickly.
However, with the economy currently growing at only slightly more than 2% annually, since the turn of the century, and inflation running well below the Fed's 2% target, what incentive is there in raising the overnight lending rate? In my opinion, none. Let me explain.
Friday's employment report, which was not surprising in its decline, is a reflection of the deterioration in the economic data over the last two-quarters. That weakness can clearly be seen in the Economic Composite Index (click here for construction) which has fallen since the end of QE3. (Gold squares show start and end of Fed's QE programs)
"While it is an accurate statement that the U-3 unemployment rate, as reported by the BLS, has dropped to 5.5% as of the latest report, there is much controversy surrounding the validity of that statement. (For more on this read: What Is The Real Unemployment Rate?"
However, it is quite hard to suggest that 94.5% of the population is employed, when almost 93 million individuals are no longer counted as part of it. However, when it comes to creating economic growth, it is only full-time employment that matters. Full-time employment fosters higher income levels, promotes household formations and increased consumption. In an economy that is roughly 70% driven by consumption, the "quality" of employment is much more important than the "quantity."
The actual state of employment in the U.S. is likely far weaker than headline statistics currently suggest. If this is indeed the case, it creates a potential for policy mistakes that could have very negative consequences for both the economy and the financial markets.
While the Fed is "committed to policies that promote maximum employment" there is little evidence that the trillions of dollars injected into the domestic economy have had any real effect on improving employment beyond what would have been expected due to population growth.
More importantly, while the Fed has inflated asset prices to the satisfaction of Wall Street, it has done little to improve the economic prosperity for a bulk of the middle class.
While the majority of economists and analysts continue to be confused by the ongoing sluggishness in economic growth, the Fed is likely embarking on an interest rate increase cycle out of "fear" more than anything else. With the current economic cycle more than six-years into a recovery, the risk for the Fed is getting caught in a recessionary slowdown with interest rates at zero.
Such an event would be extremely restrictive to the Fed's ability to limit the impacts of a recession and would jeopardize the fragile underpinnings of the current economy.
The economic data from March clearly suggests that the Federal Reserve should remain on hold, particularly since increasing interest rates is a policy used to "slow" an overheating economy. There is clearly no sign of that currently.
Economic Data To Bounce In Q2
If you take a look at the economic composite index above you will see that it has been trapped within a cycle of economic weakness offset by a "restocking" cycle as inventories were depleted. This boom/bust cycle also explains that while optimism during an upcycle increased, those hiring and activity plans never really came to fruition as the next down cycle kept businesses on sidelined.
The recent down cycle in activity will likely see a fairly substantial bounce in Q2 as inventories are restocked, and some pent up activity from the cold winter weather resumes. However, without the Fed's interventions this time around, as was seen during the previous ramp up in activity in 2014, it will be interesting to see just how strong that bounce in activity actually is.
S&P 500 Remains Bullish
Despite the recent weakness seen since the beginning of this year, the market has remained solidly in its uptrend that began in December of 2013. Since that time, the markets have proceeded in one of the longest stretches in history without a 10% correction or more. This is abnormal by any measure and has been a function of investor exuberance and continued hopes of ongoing Central Bank interventions globally.
The daily chart of the S&P 500 below clearly shows that the 150 day moving average has formulated the underlying support of the current bull trend. The break of that support this past October should have culminated in a much bigger decline. However, that V-shaped recovery back into the bull trend, spurred by Federal Reserve member Bullard's comments and Japan's expansion of its QE program, kept the overall momentum alive.
I have noted in gray the previous consolidation that occurred from December through January of this year. That consolidation was eventually resolved to the upside, and the markets were able to obtain a marginal new high.
As noted in red, the current consolidation is still at work and has not yet resolved itself. A breakout to the upside should allow for marginal new highs to once again be established. This outcome is quite likely given the current momentum of the market.
This is why, in the short-term, the model allocation remains fully invested. As long as the bullish trend remains intact, there is no reason to become more defensive currently.
Long-Term Picture Is Changing
However, as we step out and view longer term time frames, while the bullish trend still remains clearly present, there are warning signs becoming much more evident.
The next chart is a weekly chart.
As shown the bullish trend remains firmly in place, and the consolidation process continues. Just as in the daily chart. Important support lies at the 2034 which is the longer term bullish trend support and at 1990 which is support running back to the middle of 2014.
The markets are becoming overbought, as shown in the lower part of the chart above, and suggest that even if the markets do break out of the current consolidation, there is limited upside from current levels.
It is the monthly chart below which is the most concerning.
On a monthly basis, the markets are currently throwing off warning signals that have not been seen since the last two major bull market peaks. I have noted the turning points above.
While there is a large gap between the short and long-term moving averages, which confirms the current bullish trend, it is important to note that can change very quickly.
For me, it is that MACD signal that is most important and something that I noted this past week:
"Jeff Saut, Raymond James' Investment Strategist, has been a raging stock market bull for quite some time. He is also firmly of the belief that the U.S. markets have re-entered into a secular bull market that still has years left to run. However, despite his ongoing bullishness, he did pen some very interesting points on some 'red flags' that currently exist in the market. To wit:
"Another 'uncle point,' I wrote about last Thursday is the 2060 level for the S&P 500. Hereto, a close below that level would not look good to me. Meanwhile, the MACD indicator is currently flashing the same type of warning signals it did in 1Q00 and 4Q07, not that I expect similar downside results.
Then there is what Jason Goepfert, of SentimenTrader fame, wrote about last week. To wit,
"Buying power available to investors is near an all-time low. The NYSE Available Cash figure has dropped to one of its lowest levels, and the last two times it was near this level, stocks struggled in the months ahead. According to the American Association of Individual Investors, mom-and-pop investors have their highest exposure to stocks since 2007, and nearly their lowest cushion of cash since 2000."
While Mr. Saut suggests "he does not expect similar outcomes this time," the real question is whether or not you can afford for him to be wrong. After all, it's not his money at risk now is it?
Hold For Now
While there is very important deterioration in the long-term monthly picture, any serious change in trend will take some time to form which should give us plenty of warning to change allocation models.
In the shorter-term, despite the deterioration in economics and fundamentals, bullish sentiment and the trend both remain positive. This keeps our allocation model fully weighted.
A healthy program of rebalancing and profit taking is always suggested. As I have written many times previously:
"A bountiful garden is one that tended to regularly. It is fertilized (savings), regularly weeded and pruned (take profits, sell losers) and the bounty is harvested (sell high) and then replanted (buy low.)"
It is a fairly simple thought process that is somehow dismissed by the impact of greed when it comes to a rising market. The "fear" of missing out eventually leaves the "fruits to rot on the vine" and the "weeds eventually reclaim the garden."
It is clear that the garden has blossomed fully over the last five years. If you haven't been to harvest, you may want to consider it.
Have a great week.
Disclaimer: All content in this newsletter, and on Streettalklive.com, is solely the view and opinion of Lance Roberts. Mr. Roberts is a member of STA Wealth Management; however, STA Wealth Management does not directly subscribe to, endorse or utilize the analysis provided in this newsletter or on Streettalklive.com in developing investment objectives or portfolios for its clients. Please read the full disclaimer.