Monday, May 26, 2014

Time for a growth scare?

As Joe Wiesenthal recently noted, it's the moment of truth for the US recovery and expectations are rising for faster growth:
All the pieces are in place for the U.S. The fiscal drag is fading. Household balance sheets have improved. State and local bloodletting is coming to an end. If not now, when?
Indeed, the major US large cap equity averages pushed to new highs last week. The fundamentals appeared positive and supportive of the advance. Notwithstanding any unexpected shocks from the Fed, what really matters to stock prices are earnings. Ed Yardeni`s analysis show that forward 12 month earnings continue to rise, while past periods of flat growth in 2011 and 2012 have been marked by market corrections.

The Citigroup US Economic Surprise Index has been advancing, as the rate of high frequency economic beat-to-miss-rate rise.

So far, so good for the bull case.

Signs of weakness
However, there are signs of weakness beneath the surface. Global growth is slowing. Societe Generale (via Pragmatic Capitalism) showed that the Citigroup Economic Surprise Index has been weak everywhere except for the US. Could a global macro growth slowdown be around the corner?

Ed Yardeni also pointed to signs of a global growth slowdown from falling oil demand:

The US economy is in the mid-cycle of its expansion. This part of the cycle "should" be marked by rising employment and consumer spending, as well as increased capital expenditure and capacity expansion. Yet, we have seen scant evidence of the CapEx rebound (see What the equity bull needs for the next phase and CapEx: Still waiting for Godot). The recent CAT report indicating sluggish sales growth continues to be a disappointment in that respect.

I have detailed in this blog over the last several weeks the technical concerns I have had about this stock market (see The bearish verdict from market cycle analysis and Market correction or consolidation?). I wrote that one of the key "tells" of the health of this latest bullish impulse is the performance of mid-cycle cyclical and capital equipment stocks.

The warning from cyclical stocks
Last week, they cracked, even as the major averages rallied to new all-time highs. The chart below of the relative performance of the Morgan Stanley Cyclical Index (CYC) show that cyclical stocks have definitively broken down out of a relative uptrend. Up until recently, it could be argued that the relative uptrend was a little wobbly but remained intact. The latest technical verdict from last week's market action was clear. No matter how you manipulate the trend line, the technical break was unmistakable.

As confirmation, I constructed an equal-weighted Cyclical and CapEx Index consisting of CYC, Industrial stocks (XLI) and semi-conductor stocks (SMH) and measured their performance against the market. As the chart below shows, this composite index also showed a technical breakdown out of its relative uptrend.

In addition, Mish pointed out that Treasury yields have been falling, not rising. While a falling long bond yield could be explained by pension funds buying long duration assets in order to lock in last year's stock market gains (see my previous post A funds-flow reason for equity market weakness), an across the board decline in bond yields is more likely to explained by Mr. Bond Market anticipating economic deceleration, not acceleration.

These warning from cyclical stocks and the bond market suggest to me that the US is unlikely to be able to de-couple from the rest of the world. A global growth slowdown will eventually affect the US economy and the markets are starting to price in that possibility.

Watch estimate revisions!
I have also thought of technical analysis as a branch of behavioral finance. In effect, the technical condition of the market tells me the state of market expectations. Right now, we have:
  • Early cycle interest sensitive sectors rolling over after leading the market higher from the 2011 trough;
  • Mid cycle sectors like Consumer Discretionary have weakened; 
  • Business-related mid cycle sectors like Cyclical and Industrial stocks are now starting to lose their leadership status;
  • Late cycle sectors such as Materials and Energy are turning up on a relative basis; and
  • Defensive bear market sectors such as Utilities and Consumer Staples have become the market leadership.
Current conditions have market fundamentals and technicals disagreeing. Market fundamentals point to a continued expansion, while market technical conditions are highly suggestive of a growth slowdown. I don`t know how a slowdown would unfold, but as an example Across the Curve featured a Barron's interview with Stephanie Pomboy who postulated a US slowdown based on the removal of QE:
Barron’s interviewed Stephanie Pomboy of Macro Mavens this week and she presented an especially bearish view on the US economy. She argues that as the Federal Reserve stops buying Treasuries the economy will falter and the Fed might even taper the taper. She thinks there is little upside to Treasury yields and believes that the 10 year will be trapped between 2 percent and 3 percent for a long time.
Is a growth scare just around the corner? If so, we will see the first signs of fundamental deterioration if consensus forward earnings start to get revised downwards. We have already had the warning from the relative performance of cyclical stocks, the next thing to do is to watch the estimate revision rate.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.


Rik said...

The impression I get from talking with people in real business that they see a lot more structural issues than usual (and/or are careful because the down takes much longer than usual).

At the end of the day decisions there will be reflected in what we see in financial markets.

Another point is that it looks to me that communications to the outside world give a considerable more optimistic impression than when you talk to people in private. People look much more worried about sov debt, aging, structural gov overspending competitiveness of wages levels than the impression you get from the media. On top of that a lot of people simply donot see these issues properly solved, sometimes not even remotely.

So yes you have a cyclical movement but also there are reasons why the cycle is a bit different from the normal one.
Basically flatter at the upside, because people are more careful both with consumption as with investment.

From another angle. Real economy doing great means asset markets do great as well.
But the causality is not (at least not fully) working in the opposite direction as well. Good markets donot always mean a good economy (or better is not a perfect measurement for the state of the economy). Especially not when there are not pure economic reasons at play (but say QE).

Or again from another angle. Investment decisions are often based on other indicators than cycles. Basically how people think their own (sub-) market will develop. And it is hard to see where 'normal' growth would have to come from. Simply as several parts simply still look bad.
With as a consequence when you Epsilon things growth estimates often look at the high side.
And Epsiloning capex as a consequence will also be lower.
Leading to a flatter upturn.

Anonymous said...

Unrelenting. It's as though the powers that be reads blogs and knows technical analysis. If a support line fails, bring price back up. If financial or cyclical sector break trend, bring em back up. If momo are in a downtrend, stop the decline. If head and shoulder is about to form, stop the left shoulder from forming. Its as though someone knows all the potential resistances and supports and is there to nudge the price in the "right" direction. Let the market carry it from there.

At some point, I need to catch on and go with the flow.