Monday, April 5, 2010

Too hot, too cold or just right?

Dave Frost at Oilprice recently observed that there appears to be positive turnarounds in a variety of economic indicators. Moreover, job postings are rising across the board in all industries. State taxes are on the rebound. As well, ISM manufacturing data also appears to be robust.

Is the US economic rebound poised for another upleg?

Instead of trying to analyze backward looking economic releases, I prefer to look at the market’s response, which are more forward looking and the signals are available in real-time.

Real-time market data pointing to a rebound
Consider the US non-farm payroll release Friday. Robert Hall at NBER believes that the NFP release makes it clear that the recession is over, the bond market agreed with Hall by selling off, which is often an indication of a stronger economy.

With the ten year at 3.94%, the yield has moved through an important resistance point on the charts:

Commodity prices are on the rise. The chart below of the Reuters/Jeffries CRB Index shows that it is testing a resistance level. My Inflation-Deflation Timer model, which is currently in neutral, is flirting with an “inflation” reading which would shift asset allocation from stocks to commodities.

Sound the "all clear" for the stock market?
What do these positive economic indicators mean for equities? Would a new upleg in the economy mean another upleg in stocks?

Not necessarily. Financial markets tend to be imperfect forward looking mechanisms, while economic indicators tend to have a backward looking bias. Anyone trying to use backward looking indicators to try and forecast a forward looking indicator is more likely than not to lose money. Before the bulls go all-in, consider the following dark clouds on the horizon:

  • The upside breakout in bond yields can’t be good for stocks longer term.
  • Jim Grant is downgrading the US credit rating and therefore forecasting US rates to rise, mainly because of negative assessment of credit risk. Grant went on to characterize Treasuries as warrants on a macro-economic outcome and quipped that you will find better bargain in your hotel minibar than in Treasuries.
  • Bespoke’s report of stocks over the 50-day moving average indicates the market is overbought (which doesn’t mean that it can’t stay overbought for some time).
  • The ECRI Weekly Leading Indicator seems to be rolling over and there are indications that it may be negative for stock prices.
  • I have also expressed my reservations about the impending macro-economic risks (see comments here and here).

When does good news become bad news?
For now, good news is good news for stocks, i.e. good economic news makes stocks go up. At some point, good news becomes bad news because of the fear that the Fed may use positive economic news as a reason to remove accommodation.

The Federal Reserve is walking a fine line in its behavior. The world just went through a financial crisis of gargantuan proportions. The fiscal and monetary authorities decided to stimulate the economy in response. But stimulate too much and you get runaway inflation. Stimulate too little and you will keel over back into recession. You just have to get the stimulus just right - and can we count on the Fed and the US government to do that in such a fragile environment?

My inner trader tells me to stay with the trend, but to watch for technical divergences and shifts in sentiment.

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