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

Rear mirror view of the global economy

The OECD Composite Leading Indicators for November are out. Below are results for the world's four biggest economies. Notably, only US is growing although near stall speed.

Figure 1: OECD LEI for November 2014.

The OECD LEI is already two months old  at the time of publishing. In a sense, it gives as a rear view of what may happen. This has happened in the last two months: Ruble collapsed, oil collapsed, and other materials are in free fall. This is seen in the Global Growth Barometer below. 

Figure 2: Global Growth Barometer and SP500.

Materials and yield spread are signaling weakness. Quoting John Hussman: 

"the plunge in oil prices and safe-haven Treasury yields, coupled with the rise in yields on default-sensitive assets such as junk debt is most consistent with an abrupt slowing in global economic activity"

Note that Global Growth Barometer and SP500 have decoupled in 2014 and this decoupling has accelerated. Investors are ignoring clear signs of economic weakness, for now at least.

SP500 price to trailing twelve month earnings

Trailing twelve months is too short time frame to measure long term earnings potential. Nevertheless, past twelve months earnings (Ettm) is often used as a short hand for real fundamental analysis. Figure below shows the SP500 vs Ettm. Currently, the P/E=27 which is high by historical standards but not a record. Again, just one year P/E is not very predictive of the near future but it shows that stock market is not cheap.

Figure: SP500 vs. trailing twelve month earnings.

Chart update for end of 2014

2014 is over. The year market another up year for SP500 and another year without -10% correction. Records are being broken. Yet, the theme for 2014 for increasing market divergence across the sectors:

Fro longer term view, the similar divergences are shown for 2011 just before the market drop but the divergence have lasted now for 12 months. Market is stretched - and this is an understatement.

Could the market stretch further. It is possible but unless the divergences are repaired, any rally from here is on borrowed time.

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. 

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.

Weekend update 11/28/2014

Black Friday closed with ominous note: Breath deteriorated substantially and sentiment turned even more defensive. The backdrop for the turbulence is the plunge oil price the directly hurts energy sector and related high yield bonds. The high yield dropped and treasuries rose. The continuing divergence between the high yield and treasuries is the most dangerous alarm of rising risk aversion that is yet to affect the large cap stocks. Other divergences:

Against the breath weakness across variety of assets, Friday also showed a sharp move in treasuries that has previously indicated near term weakness in stocks:

All indications point to weakness in the coming week.

Why credit spread matters

Credit spread, the difference between risky bonds and risk free treasuries is a good indicator of investor risk tolerance. Widening credit spread indicates that investors are becoming more risk averse and are seeking safety in treasury bonds. This sentiment is reflected in the stock market. Figure 1 (top panel) shows the correlation between changes in credit spread and SP500 price. The correlation is not perfect (they never are) but this is about as good as one gets in finance.

Figure 1: Correlation between credit spread changes and SP500.

Periods of widening credit spread (red line on bottom panel) can be very risky for stock market.  This indicator alone is not sufficient in avoiding all market drops and it has given a few false warnings. Where it has worked big time is in avoiding large draw downs in 2000 and 2008. This indicator has also worked well since 2009.

Currently (11/25/2014), the credit spread is giving another warning. Combined with lofty valuations, the caution is doubly warranted.

Re-establishing correlation between large caps and small caps

The relative under performance of small caps have been a theme of 2014. For bears, this has been indication of risk aversion and top formation. But what if the small caps were just waiting for the large caps to catch up?

Figure 1: After over-performing in 2013, the small caps have waited for the large caps to catch up.

The market is nearing a decision point: Several indicators are still divergent but the market breath and uniformity have also been on the mend. Now that the large caps and small caps have re-established their correlation, the next move for them will likely be in the same direction.