Leading indicators lagging?

Dallas FED came out today and it was decidedly negative:

The negative economic data is not surprising given the overall economic weakness combined with low oil prices hitting Texas especially hard. But the data is in odds with the leading index for Texas from FRED:

The leading indicator is showing upward sloping curve with no hint of weakness. One explanation for the divergence is that leading indicators use monetary signals such as credit spread and yield curve as their components and these monetary signals are now heavily manipulated by FED. It is possible the leading indicators will not be as useful as in the past in predicting the next recession. Proceed with caution. 

Coincident and leading data for US economy is weak

This week, we had update on durable goods and housing. With the latest data points, the "hard data" average for the US economy is weak:

This type of weakness is normally associated with recession. It is still early to make this conclusion: Recession is "pervasive weakness" and a few months of below average or negative growth is not yet pervasive. On the other hand, we have ECRI leading indicator also pointing to future weakness:

Finally, the US growth barometer has stabilized but is still divergent from stock market:

Stocks remain near all time high but the backdrop is negative. It will not take much the cause a waterfall declines.

OECD Leading Indicators for January

The OECD Composite Leading Indicators for January are out. Below are results for the world's four biggest economies. Notably, only US is growing but loosing steam.

This indicator is not telling us anything we don't already know. World economy is experiencing slowdown as has been signaled by commodities and Baltic Dry Index:

The current economic expansion has been artificially boosted by bringing future demand forward. This course may be reaching its limits. 

Credit spread is increasing again

After a counter rally, the credit spread has been increasing again:

While the stocks made new highs last week on FED euphoria, the worsening credit spread signals newly arisen risk aversion. Granted, the divergence between the credit spread and SP500 has persisted longer than I expected but eventually the correlation will be established. For more about why credit spread matters, see "Why credit spread matters".

Economy looks real bad for Q1 2015

Economic data has been weak in recent months. Figure below shows how coincident economic indicators are overwhelmingly deteriorating:

There is a lot of data in this figure - taking the average shows a clearer picture:

The acceleration has been fast. The effect is also seen in the FED forecast for Q1 GDP:

Market is sheering all these negative developments. There is not even a pretense that price movements are driven or related to fundamentals other than short term interest rate. But bulls have only price momentum only on their side, the price may quickly snap down.

Households still piling into stocks

The Q4 2014 flow of funds data is available from FRED and it shows that households are still moving from bonds into stocks at record pace:

Historically, households have been dumb money: For example, households sold stocks at 2009 bear market bottom and bought bonds. This time may not be any different. If economy continues to decelerate, bonds will outperform stocks. 

I was wrong

Its been obvious for a while: my call on market peak on 12/16/14 was wrong. Since then, all major indexes have made new highs.

I was early but tide may be turning. This week saw a modest sell-off but nothing resembling panic selling. That will surely follow as it becomes obvious that US economy is not immune to global slowdown. Signs are becoming more evident:

ECRI weakly growth is stuck at -4%

Inventories to sales ratio is at recessionary levels: 

The producer price index is at level that has only been seen in recessions: 

Finally, insiders are bailing out (source: Nautilus Research):

So although I was wrong in December, I still believe that a larger correction is coming and it may just be a few weeks away. 

BDI about to roll over?

Baltic Dry Index has bounced in the recent weeks. This has given some support to shippers’ stock prices but the lift may be short lived: As Figure 1 shows the bounce is seasonal and about to roll over.  I am bulk shippers as prices are low compared to book values; but with the industry bleeding money and China slowing fast, it is prudent to wait.

Figure 1: Seasonal variations of Baltic Dry Index

Correlation between ECRI leading index and stock market

The ECRI weekly leading index growth and SP500 change track each other as shown in the plot below.

Figure 1: Correlation between ECRI LEI and SP500

The correlation is good, nearly 80%. This is not a surprising given that

1. SP500 is a component of ECRI.

2. Stock market usually reacts to other components of ECRI. For example, higher unemployment claims indicates cooling economy which drives stocks prices lower.

What is surprising is that this correlation has been broken recently. Whereas the ECRI growth has been negative, the SP500 has been making new highs. Similar broken correlations are seen other historically reliable indicators such as credit spread and SP500.

There is combination of forces at play:

1. Investors are betting that current weak data is passing and will not affect longer term prospects of US economy.

2. We are in later stages of bull market where majority of investors are all in. By definition of all in, there are no sellers, just buyers, and price keeps going up.

3. Stocks bubble is being blown by the central bank narrative. In this narrative, fundamental analysis is not important and good news may actually be undesirable.

At the same time, the rally is running on fumes. As seen by the margin debt peaking (plot below), there is little fuel left for further rally. All that is needed for sell off is a slight change in psychology where minority of investors decides to hold cash rather than stocks yielding less than 2% dividends.

Figure 2: Margin debt has peaked and is in down trend.

All time highs with weak breath

February saw a powerful risk-on rally with stocks. Notably cyclical sectors and broad market rallied reversing some of the defensive posture that has been building. This has resolved some of the glaring divergences in market. I was expecting the divergences to be resolved by pull back in large caps but for now, it is still a bull market.

So divergences remain: The credit spread is still flashing red (HYG/TLT), 1/VIX is still in the downtrend, and new highs/lows signal weakness at ATH. The market is weaker than the headline number suggests.

Slowing global trade and US economy

The collapse of Baltic Dry Index and commodity price indexes are well documented. BDI is at historic lows and and CRB is at levels last seen in recession.

Both point to rapid deceleration of global and especially Chinese demand. Less attention is given US trade that is rapidly slowing. The exports are down which is natural given the global weakness:

More ominously, imports are also down:

Container volume in west coast ports is down:

Overall, the picture painted by the trade numbers is negative. With leading indicators also down, 2015 may be less strong for US economy than predicted.

 

SP500 making new all time highs with weakening global economy

Greece and Ukraine are capturing news headlines while smaller news point to continuing global economic slowdown. First, the US growth barometer is still showing weakness despite a small bounce in oil prices:

This weakness is confirmed by ECRI weekly leading index:

The weakness in materials also shows in inflation which is at levels only seen in recessions:

Baltic Dry Index that measures the cost of bulk shipping is at historic lows:

Despite this backdrop, SP500 is making new highs. For time being, stocks have decoupled real economy and main news moving the market are related to FED interest rates. 

Credit spread recovering but not enough

Market is still trading in the range but internals have recovered a bit. Enough to reverse the bear course?

The credit spread below shows stabilization and a small uptick; however, the stock market is not confirming. The chart shows two other instances of credit spread leading the stock market down, recovering a bit but stock price fails to make new highs. Subsequently, the downtrend was quickly established for both. The lesson here is important. Unless stocks can quickly establish leadership here, we will likely start making lower lows.

Figure 1. Credit spread and stock market.

Figure 2. Shows the ECRI weekly leading index. It continues to show weakness. It is worth noting that SP500 is a component of ECRI LEI and LEI is down even with SP500 holding up. If the stock market starts loosing altitude, the ECRI LEI will follow.

Figure 2. ECRI LEI and stock market

Realities do not matter

It is clear that the market will go higher in absence of negative news. The following news could have been perceived as negative but they did not affect the market:

1. War in Europe (Ukraine) and Russia annexing its neighboring territory unilaterally. 
2. Recession in Japan. 
3. Slowing growth in China. 
4. Eurozone deflation. 
5. The most negative earnings guidance for SP500. 
6. Plummeting commodity prices signaling global slowdown. 
7. Almost total collapse of the world’s 9th largest economy (Russia). 
8. Utter collapse of Baltic Dry Index again indicating global slowdown. 

It is obvious that stock market has decoupled from realities. Equally obvious is that it is hard to predict when the reality will catch up with the market. The rising volatility, however, indicates that the market is on borrowed time.

Down, Down, Up, Down, Up

The last five trading days: SPY down 1.3%, down 1.3%, up 1%, down 1.2%, up 1.3%. In this context, today's action is not at all bullish but just another example of market confusion. Remainder: Stocks have decoupled from fundamentals such as geopolitical news or global economy. This is seen in the breakdown between US Growth Barometer and stock price:

Given the breakdown between stock price action and fundamentals, the day-to-day market action is unpredictable. Longer term, the fundamentals will act like gravity on stock prices.  

Up momentum exhausted

Since the last week's post "Situation unchanged", the market has turned more bearish. The breath indicators remain largely unchanged but the up momentum is now exhausted. This is seen for example in the oscillators shown below:

SP500 is at were in has bounced up now several times. Changes are that there won't be a bounce this time around and the market breaks sharply lower.

Situation: unchanged

The ECB action come largely as expected. The Pavlovian reaction to buy stocks lasted a day. On Friday, US stocks were already on going down. And why not: QE in EU makes the dollar stronger thus weakening US corporate experts and lowering their overseas profits.

Looking past the day to day fluctuations, the situation remains unchanged:

1. Leading and concurrent indicators are down.

2. The credit spread is increasing:

3. Safety is the word in stock markets. The breath is deteriorating.

Unless the picture changes these dynamics change, the market is heading down.

A, B, or C

The divergence between credit spread and stock market has been widely noted in financial media. Often weakening credit spread signals loss of risk appetite and impending correction in stocks. But not always. Note area A in the figure above. Credit market signaled steep decline that did not materialize. Usually, the stock market and credit market decline simultaneously as in B above. And then we have C where credit spread preceded steep decline in stocks.

So is the current decline A, B, or C? B is ruled out by comparison (stocks and credit do not move in sync). It does not look like A either: the credit spread increase has been prolonged and sustained lasting over 6 months. And this happens in the very mature bull market and with the backdrop of deteriorating financial news.

This leaves C: Credit is signalling steep losses for stocks in near future (next few months). 

Move to safety accelerating

Choppy week with volatile price action. The market rallied on Friday on no news. This is not a sign of strength but nervousness. Behind to hood, the move to safer assets actually accelerated:

Speculations are rampant on ECB starting QE next week. Perhaps this will be "sell the news" event that finally rolls the big caps over.

FED behind in raising interest rates

Job openings in the private sector is a good indicator of the economic state. Lots of openings means that companies are hiring but it may also mean that there are not sufficient labor force available to fill the jobs. This leads to wage growth and inflation. Not surprisingly, FED will tend to raise rates in tandem with job openings. In this recovery cycle, FED is woefully behind the curve:

Those who expect that FED will not raise rates as they are indicating, may be surprised later this year.