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After a rocky start to the summer, stocks have trended higher over the past few weeks. That much is fact. So why do I remain leery of the market? What are MY indicators telling me about this rally? Can this uptrend really hold?
Those are the most important questions I want to answer for you. But to give you a sneak preview: No, this doesn’t look like the start of a major new run!
Warning Sign #1:
Dow Industrials vs. Industrial Activity
The Dow Jones Industrial Average is hovering around the 13,100 level. As the name suggests, of course, the industrials should generally track activity in the manufacturing sector of the economy. If manufacturing activity is rising, revenue and earnings growth will rise. If manufacturing activity is falling, the opposite will occur.
With that said, take a look at this chart going back more than a decade. The blue line is the Institute for Supply Management’s Manufacturing Index (ISM), the most widely followed index tracking domestic production. The red line is the Dow Industrials.
You can clearly see that they do generally track each other. The two glaring exceptions:
The first was in 2007, when the Dow managed to levitate despite a slow, steady downtrend in manufacturing activity because we were in the last throes of the housing and mortgage bubble.
And the second is … NOW! The ISM index has slumped all the way to where it was in the summer of 2009, yet the Dow has still managed to rally.
Let me ask you this then: With the benefit of hindsight, wouldn’t it have made complete sense to heed the ISM’s warning in 2007-2008? Wouldn’t you have been better off if you didn’t chase that last rally on fumes, and sold stocks before the sickening plunge that followed?
Warning Sign #2:
S&P 500 vs. Interest Rates
As I’ve alluded to in earlier columns, I believe bond traders are generally “smarter” than stock traders. They’re usually more level-headed, focused on the fundamentals, and oftentimes EARLY when it comes to major changes in trend. So you can be sure I pay very close attention to what they’re doing with their hard-earned money!
One indicator I watch closely is the 2-10 spread, the difference in yield between 2-year Treasuries and 10-year Treasuries. When the economy is expanding and demand for money is strong, this spread widens out. When the economy is weakening and demand for money is falling, it narrows. And it’s generally a VERY ACCURATE recession warning when the spread goes negative!
With that preamble out of the way, take a look at this updated chart comparing the Standard & Poor’s 500 Index to the 2-10 Treasury yield spread. You can see that over the long term, stocks tend to track this expansion/contraction indicator. That makes sense because profit and sales growth expand and contract with the economy!
The spread diverged from stocks for a while in the blow-off phase of the housing bubble — and now, it’s diverging again. You probably don’t need me to remind you what happened to investors who failed to heed the bond market’s warning last time. They got killed!
Would you agree, then, that it makes sense to pay attention to this warning sign THIS time?
Warning Sign #3:
S&P 500 vs. Corporate Earnings
Corporate earnings are supposed to be the lifeblood of the stock market. After all, shares of stock represent an ownership interest in the profits that a corporation spins off. When profits rise, stocks prices tend to rise, and vice versa.
Now take a look at my third chart. It compares the price performance of the S&P 500 to the year-over-year rate of growth in S&P 500 earnings (excluding financials). Between 2009 and 2011, they tracked each other fairly well.
But look at what has happened since then!
Corporate earnings growth has been dropping like a rock — from 17.2 percent in mid-2011 to 4 percent in the first quarter of this year. With roughly 9 in 10 S&P 500 companies already reporting second quarter earnings, we’ve even swung into the RED! Earnings are shrinking at a 1.6 percent rate, the worst performance in three years!
Yet what has the S&P 500 done in response? It has come unmoored from underlying profits, rising to around 1,400 in the past few weeks.
Once again, I will ask a simple question: Does it really make sense to ignore across-the-board deterioration in corporate profits? Especially when consensus estimates now call for ANOTHER profit decline in the third quarter?
The ONLY Prop for Stocks?
So what’s the only major prop out there for stocks right now? What’s driving the latest round of buying? Simple. Hopes for more quantitative easing (QE) and bond buying here and in Europe. That’s it.
Therefore, anyone on Wall Street chasing stocks higher here is basically betting that printed central bank money can offset deterioration in the real economy and corporate earnings forever. He or she is also betting that “this time is different” when it comes to reliable interest rate indicators that have worked for decades.
Me? I don’t like those odds. So outside of a few selective picks here and there, I’m not eager to chase stocks.
Until next time,
Mike
P.S. In the August edition of my Safe Money Report, I showed members how to get extra income in this topsy-turvy interest-rate world! To learn how you can join them — RISK FREE — for only 14 cents a day, click here.
Mike Larson graduated from Boston University with a B.S. degree in Journalism and a B.A. degree in English in 1998, and went to work for Bankrate.com. There, he learned the mortgage and interest rates markets inside and out. Mike then joined Weiss Research in 2001. He is the editor of Safe Money Report. He is often quoted by the Washington Post, Reuters, Dow Jones Newswires, Orlando Sentinel, Palm Beach Post and Sun-Sentinel, and he has appeared on CNN, Bloomberg Television and CNBC.
{ 7 comments }
So where should a person put their 401k money to preserve it when stocks and bonds are risky?
I understand a massive number of Put Options have been placed on US and UK. A massive amount; just like it was 5 days before 9-11 occurred.
Will you address this please?
Mike, Its a good article, but I’d like to present the other way of looking at this data.
I look at the data and say, “yes, its true, the American Economy is in a fragile state, but does this mean the economy is going to implode as you suggest?”
At first glance the the divergence of the ISM index vs the Dow (in the first chart) would seem to presage a terrifying and catastrophic decline to come. But this is not necessarily the case. True the ISM did diverge significantly from the Dow from the beginning of 2003 to 2007 when the market collapsed. But I think its important to determine cause and effect to understand what’s really going on. While its true the market was over valued in 2007 The ISM the collapse in late 2007 to early 2009 was a result of the collapse of the financial system due to the Lehman bankruptcy, than because of a decline in the ISM. The cause was the financial crisis. The effect was a lower ISM.
Looking at the situation today, its true there are grave risks emanating from Europe, and also the approaching fiscal cliff, but the difference between then and now is a change in attitude. In 2007 the powers that be (namely Paulson and the Bush Administration) were locked into an blinkered, ideological view of the world. I.E. that saving Lehman Brothers was completely unacceptable. Until this point it was the perceived wisdom of the financial world that faissez-faire free market ideology was the solution not the problem. The Lehman Brother’s collapse changed that paradigm.
And, although mistakes were made, Paulson et all, were smart enough and pragmatic enough to adapt to the situation and change their minds as to how to handle the situation. In fact, this is the silver lining which may ultimately save our bacon. America showed the way as to how to handle a catastrophic collapse of financial system. This was a useful lesson for dithering Europeans to learn from.
Chart 2 shows an unprecedented divergence between interest rates and the Dow. Clearly the cause of the divergence is the historically low interest rates that have pushed stock prices up. Interest rates are now at all time lows.
However, I think what is more significant (and contrary indicator) is the huge volume of money that has flowed into bond funds. In the week of July 18, 2012: $646 billion was put into bonds. That is an extraordinary amount of money. What is disturbing is that investors have bought these bonds at the very bottom of the interest rate cycle. If interest rates go up (and eventually they will) huge numbers of investors are going to be slaughtered.
The other point is that there is a huge amount of cash (I think $2.5 Trillion) sitting on corporate balance sheets. Perhaps this explains why investors are investing in Blue Chip stocks whose dividends are also substantially higher than bond yields.
However, the third chart is what worries me most. It indicates that corporate earnings might have peaked out for the foreseeable future. But then again perception of reality is what drives economic activity. Its clear that there are risks confronting the world economy going forward. But as Donald Rumsfeld would say, there are “known risks” and “unknown risks”. In 2007-2008 by and large the world faced “unknown risks”. Today the world faces “known risks”. While its true that European Politicians have dithererd, my reading of the situation is that they are increasingly adopting the playbook established by Paulson & Co. There is also an acknowledgement, and frantic lobbying by American business, not to permit the childish and dangerous game of chicken that Tea Partiers precipitated with the debt ceiling crisis in 2011.
Its too early to tell what the outcome of the 2012 Presidential Election will be. What ever the result hopefully the American people will give who ever they elect a substantial mandate to run the worlds most important economy effectively. The worst thing that could happen is if the same dysfunctional status quo politics that have plagued America for the past 12 years. A clear mandate by the American people will send a powerful message to the markets. All the negative stuff that is factored into the markets could evaporate very quickly.
Personally, I am bullish on America and the American way of doing things. It is an economic system that has proven to work and has been copied by every economy from China to Brazil. The only thing that is preventing prosperity to flourish again in America is internal politics and squabbling. That more than anything else is what is holding America back.
In the mean time I will be using Warren Buffet’s approach of using market declines to pick up some of the world’s best run companies at dirt cheap prices.
Dear Richard,
after reading your comment it seems to me that you are living in phantasy land. You just did not get it what is going on in the USA. Perhaps you should start to open your eyes and take a deeper look around. Therefore i strongly advice you to start reading zerohedge, the market ticker, the comments of John Hussmann and Mike Shedlock. And stop listening to the FED idiots, the idiots in politics (excluding Ron Paul), the nobel prize idiots like krugman and the idiots on CNBC (excluding Santelli). The point is, at the end facts always win.
Richard, I agree. The 2008 meltdown is remarkable when you consider how Paulson et. al. took a “no bailout” attitude which ultimately led to much more substantial bailouts than if they’d simply bailed out Lehman.
It was remarkable how they did a 180 turn, essentially saying “ok, ideology is great… but now we’re talking about the real world… and our ideology just started an avalanche.”
The other remarkable thing is how, after the dust settled, those guys are back to promoting the ideology (that it’s “just a free market,” “markets sort themselves out,” etc.). They backpeddled on their ideology using the excuse “too big to fail.” But, after 5 years of banks (like Chase) absorbing banks (like Wash. Mutual), these institutions are even bigger! And the ideologues are back to preaching how it’s “just a free market.”
There’s a really good PBS Frontline documentary about that crisis-induced flip flop (where Paulson went from hard-line free marketeer to pragmatic bailer outer. It’s called “The Meltdown.”
Sorkin’s book “Too Big to Fail” gives even more insight into how these “free market” guys became “big government” advocates overnight.
Mike, may I remind you that you felt the same way in 2009, 2010 and 2011.
How are those inverse ETFs doing for your subscribers?
It seems the above Richard Gordon is a socialist who doesn’t mind the govt stealing his dough to give to banksters to run up the markets with. And for politicos in charge of the Plunge Protection Team to misuse their assigned duty to buy into the market with the public’s money in order to let it down more slowly rather than to have it plunge drastically keeping those who want to get out from doing so; misusing it to keep the market aloft for political gain, to get re-elected.
Suppose the market were to crash now? What chance would Obama have then? Little to none as the reality of the real economy (rather than an artificially propped up in key areas) would be apparent.
I understand people simply don’t want to believe in manipulation. They act like ostriches rather than going to find the information that is available to them on just what goes on. When there is no one to prosecute, when the other political party is as guilty as the current, then no one is looking out for the little guy.
So yes, there are great risks as Mike has pointed out. Yet they will likely be delayed until the election unless some other catastrophe occurs. So the question still remains, is staying in the market worth that risk when anything could cause mayhem?
What about the Financials? Are the post Lehman banksters now in good shape? Hardly, bank-ruptcies continue outside the news channel. They haven’t stopped gambling at all. They have doubled down and are losing again with house prices still falling. How many hundreds of trillions in losses do they hide with mark to fantasy accounting and in their offshore divisions? And simply off the books? Some estimate more money than the world contains. Meaning they are dead broke and kept alive with continual infusions of your money via the Fed and the Treasury. All to delay the inevitable, making it much worse when the day of reckoning comes.
Those who remain in the market will be glad they did, right up until they aren’t glad anymore.
If Romney gets elected there could be a mood meter reaction for a time until reality returns that govt isn’t the solution, it is the problem.
The coming harsh times will last 10 times as long due to what Mr. Gordon above thinks was a good move. I’d rather have 2 yrs of semi bad times than 20 years of harsh times sprinkled with interludes of fairy dust and fake outs as with previous depressions.