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.

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.

Divergences abound

Divergences can remain divergent for long time. But longer they remain, the more they matter in the end. Current divergences are breaking some records in the market. Below are some examples:

Figure 1: Credit spread divergent from stocks.

Figure 2: Stock market breath is divergent.

Figure 3: US Leading indicator is divergent.

Figure 4: Materials are signaling global slowdown.

It is hard to find more glaring divergence in the market history. When the market turns down, the move will be violent.

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.

Households are all into stocks

Households are usually not the best market timers; they tend to get nervous and sell near market bottom and buy near the high. Keeping this in mind, the following chart is sobering:

In 2008-2009, the households pulled out record amount of money from stocks and bought bonds and treasuries. In retrospect, this was a good time to buy stocks. 

Since 2013, household have moved money from bonds and treasuries into stocks at record pace. I predict that this would be a good time to do the opposite and pull out from stocks.

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. 

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.