Global Growth Barometer signaling slowdown

Global Growth Barometer tracks the movement of most important commodities. Its correlation with the stock market is far from perfect but it still tells on interesting story:

The drop in Global Growth Barometer is the fastest since 2008. Stock market is largely brushing this off as over supply issue (as opposed to slow down in demand) but caution is in order: Usually supply movements are slow in comparison to movements in demand. Unless this time is different, the global demand is experiencing fast slowdown.

ECRI weakly leading index indicates slowdown

U.S. weekly leading index from ECRI has shown weakness in the recent weeks as shown below (the shaded areas indicate U.S. recessions):

The index has turned negative after a being positive for 2013 and most of 2014. The indicated slowdown is not yet significant but it is in contrast to consensus optimism for 2015 and the record high stock market.

A longer view of this index is shown below. ECRI has quite good track record in indicating recessions but has also given a few false warnings. Nevertheless, this is an indicator to keep on eye on. 

Increasing frequency of flash crashes and dashes point to instability

SPY flash dashed on Thursday:

The total event was less than 70 ms and involved just over $100M worth of trades. These flash crashes/dashes happen now every day and are usually not noticed - the exception being the Apple flash crash on Dec. 1 that briefly took the stock down by 6%. 

The increase of flash crashes is increasing as confirmed by Eric Hunsader for Nanaex, LLC:

Combined with the deteriorating market breath, wild market swings as witnessed by last week, and wild gyrations of individual stocks, this points to unhealthy market. The last weeks V-recovery gives impression of a strong market but it is actually a sign of unstable market that is on verge of hitting an air pocket. 

The coming global recession

The news coming from Russia are dire; The country is quite simply running out of dollars:

Russian banks need bailout

Russian leadership is clueless

What does this mean? In simple terms, world recession. Below is the OECD leading index (LEI) for the four biggest economies in the world. It is already showing negative growth for three. Yes, three of the world's four biggest economies are already depressed.

And now comes the Russian shock. Russia's biggest trading partners are EU and China. The Germany's trade with Russia alone is 3% of their GDP. That will now be close to 3% negative growth. A shock of this magnitude cannot be brushed off by economy that is already teetering close to recession. Look forward to global world recession in 2015.

Market peak of everything - evidence that the stock market has already peaked

The broad selling of the stock market continues. Is this just another dip or has the market already peaked? The overwhelming evidence suggests the latter:

1. The margin debt has peaked. The margin debt reached historic high of 2.7% of US GDP on February 2014. The margin debt peak has preceded the last two major stock market peaks in 2000 and 2008 by a few months.

Source: NYSE

 2. Value of equities relative to GDP peaked in Q2 2014. This indicator has not turned down decidedly but this may be just a matter of time.

Source: FRED

3.Similarly, the household allocation to equities reached high in Q2 2014 (22% of all household assets is in equities). The equity allocation has been higher only once in 2000. In other words, there is no cash on the sidelines; the households are all in.

Source: FRED

4. The inverse of credit spread peaked in May 2014 and has decidedly broken down. This has been a good leading indicator to stock market.

Source: FRED

5. Corporate profits as percentage of GDP (a proxy of profit margin) peaked in Q3 2013.

Source: FRED

6. The corporate cash flow peaked already in Q4 2011 and has not increased since.

Source: FRED

7. The major stock markets around the world are going down in unison.

8. As are the stock indexes in US.

In summary, there is overwhelming evidence that the stock market has already peaked. Given the excessive valuation, it is likely that the market may go down significantly over the next 6 to 12 months.

Deteriorating breath turning into broad selling

The market has been selling broadly. All major indexes are down. This includes small caps that have been weak all year but also large caps, tech, and biotech that have been leading all year. The major indexes are down:

The selling is global with all indexes down.

VIX remains elevated but has not spiked further. The volume is elevated but only modestly so. In all, the selling has been orderly without a sign of panic or capitulation. Given uniformity of the action, the stock market rout will probably continue. The question is whether the selling remains contained or if this turns into a bigger rout.

Market balancing on a pin

After several weeks of increasing divergences, the large caps started to roll over. The picture is not pretty.

And the small caps (IWM):

If the support breaks, there is not much resistance below.

The narrative is that oil prices are hurting corners of the economy. And this is true: energy sector is taking in beating. The baltic dry index (BDI) is down -63% yoy as low oil prices eliminate the incentive for slow steaming. At these levels, cash flow is not enough to pay for the loans for the drillers and shippers. In the leveraged economy, it does not take much to stir a storm...

Watch for VIX and high yield:

VIX surged to 21+ which is extremely high considering that market is less than 5% from the high. Sell volume was moderate but not near capitulation level. So while the vix is high, I take it as an indication of investors seeking protection but not wanting to sell their stocks. While it is possible that market may bounce up here (especially if the price of oil stabilizes) most other indicators point to lower next week.

Weekend update 12/6/2014

Indexes did not move much: SPY up by 0.39% and QQQ down by 0.59% for this week. The divergences remain in place:

Given the small change in the headlines, we need to dig in for clues:

1. 52wk lows are on the rice, again. We also had several now 52wk lows. This triggered the Hindenburg omen which is just a fancy way of saying that markets are confused and perhaps near turning point.

2. The nervousness is on the rice. Apple flash crashed 5% on Monday. While indexes are stable, stocks are experiencing larger swings.

Overall, the big picture remains unchanged. The divergences are bearish as they have been for some time. Next big move should be down.

Signs of stock market top

There are currently quite a few signs that we are near stock market top:

1. Excessive valuation

The stock market valuation is above the historical norm. Q ratio is second highest in history. Shiller PE is over 27. When the market turns, the value conscious investors will stay away.

2.  Extreme bullishness

Even minor market dips are heavily bought. Cash allocations are low. Margin debt is high. Investor sentiment is extreme.

3. Final push/overshoot

Everyone wants to buy in a fear of missing out and no-one wants to sell. This can result in a final rapid price appreciation that stands out and makes the overvaluation just more obvious. Think about climbers reaching a summit and asking "now what?". The 10%+ price run a matter of weeks qualify as significant movement. 

4. Deterioration of market breath 

Healthy market moves in unison. Strong bullish tide carries all stocks. When this starts breaking down (more stocks making new lows, more stocks below long term moving averages), the market is about the hit an air pocket.

5. Rolling over of leading indicators

The unprecedented monetary stimulus has made leading indicators less useful in this business cycle. The current expansion is one of the longest and weakest. Looking OECD indicators, the global growth is continuously weak, near the stall speed. The US based private research company ECRI's weakly leading index growth is also negative.

6. Widening of credit spread

The credit spread, difference between high yield and treasury bonds is on the rise signaling risk aversion. This correlates well with stock market.

7. Money flows into defensive stocks (utilities and consumer staples)

This is the classical market timing method. The current bull market is a bit confused but utilities and consumer staples have been the strongest performers indicating defensive stance.

8. Increasing volatility and "nervousness"

Small daily movements become wider daily swings. The market leaders suddenly hit air pockets. Apple losing 5% intra day qualifies.

9. Emperor has no clothing moment

A wide spread recognition that something everyone already knows may actually matter. For example, everyone know in 2000 that valuation was high. Then suddenly PE>150 actually mattered. For example, housing bubble in 2008 was obvious but it did not matter as housing never went down. Until it did. Currently, everyone knows stock market is a bubble but it does not matter because of central banks. But suddenly this will change and everyone will know that everyone knows that this is a bubble.

In summary, all the ingredients for market top are in place. All that is missing is the "emperor has no clothing" moment. 

Using Topin's q to estimate future stock market return

Tobin's q is the ratio between a physical asset's market value and its replacement value. We can use Tobin's q gauge to value of stock market relative to its replacement cost:

q = (value of stock market) / (replacement cost)

Or written differently

q = P/B

where P is the price all the stocks of all the companies and B is the book price of what it would cost if we were to build the companies from scratch. In essence, q is a measurement of stock market valuation relative to their assets.

Figure 1 shows historical q for U.S. corporations. It has varied widely over time depending on business cycle, inflation expectations, and most importantly, the investor sentiment. The average q = 0.71 indicating that historically the corporations have traded below their replacement value. Currently q = 1.1 which is historically high. Only during the internet bubble years has Topin's q been higher.

Figure 1: The U.S. stock market Tobin's q.

Valuation is not a good indicator for near term market movement but it can be used to estimate longer term stock market returns. Over several years, the valuation metrics tend to revert to to long term mean. We can use this fact to estimate the future stock market return by writing the price N years into the future as

Here qAVE is the historical average q, qNOW is the current q value, g is the average growth rate for the assets, and PNOW is the current stock valuation (Geek note: derivation at the end of this article). Note that this relationship does not account for dividends.

Figure 2 shows the modeled annualized stock market returns and actual realized returns over the 7 year time span. The plot does not account for dividends and is not adjusted for inflation. Currently, the projected return is negative. With dividends included, the nominal 7 year return is about break even meaning that one could just hold the cash and avoid the stock market risk.

Figure 2: The stock market return estimate based on Tobin's q ratio.

APPENDIX: The derivation between the current stock market price and future price estimate using q ratio:

Sector rotation for market timing: theory and practice

Figure 1 shows the classical sector rotation and its relationship to stock market cycle. The theory is simple:

1. In early bull market, the financials, technology, and consumer discretionary are the best performing assets. These assets have been heavily beaten in the preceding bear market and are ready to bounce.

2. In later bull market, when business cycle has turned, industrials, materials, and energy are the best performing assets.

3. In the bear market, investors seek safety in defensive sectors that are not affected by business cycle: Staples, utilities, and health care do well.

Figure 1: Sector rotation and market cycle (theory).

If the above holds, we can use it to time the market. Figure 2 shows historical data. The correlation is not perfect but usable. The bull market in 2003 with Stage I sectors (green) showing strongest performance. Later, Stage II sectors (yellow) took over. In 2007 we had a brief warning with defensive sectors briefly leading (red) but the bull was not yet done. The bottom of bear market in 2009 was market with Stage III sectors leading (red). 

Figure 2: Historical sector rotation and market cycle.

The cycle since 2009 has been more confusing. The cycle started with Stage I sectors leading as expected but subsequently we have had Stage I, II, III sectors alternating. Currently, Stage III sectors are the relative leaders which is not a bullish sign.