Friday, January 9, 2015

Weekly Update

2015 is off to quite the start. The first few days delivered a doozy of a sell off. Then came this Wednesday with its calming Fed meeting minutes, followed by Thursday with reports of good chain store sales, the fewest annual layoffs since 1997, lower weekly jobless claims, consumer optimism that just keeps on growing, and data out of Europe suggesting that the European Central Bank (ECB) will be hard-pressed not to start buying government bonds immediately following its January 22 meeting. All in, Wednesday and Thursday were good for over 500 Dow points to the upside. Ah, but then there was today with the Dow dipping 170 points, supposedly on the negative wages news that accompanied an otherwise robust jobs report (see the economic notes below for more detail).

If you’re watching the market daily (poor you), and if it effects you (poor poor you), this was indeed a stressful week. And while I’ll never promise you anything but volatility when it comes to the near-term prospects for the market, and I’ll never pretend I know where we’re heading even in the long-run, I will share with you the things I track that have been—historically-speaking—decent recession-risk indicators. I track such things because the true bear markets (20%+ market declines that last awhile) of the past tended to have been the stuff of recessions. 

Below are my charts, all updated this week, each preceded by a brief explanation (click them to enlarge):

Recessions typically don't occur until after the treasury yield curve inverts (short-term rates exceed long-term rates). As I described last SeptemberThat’s when short-term interest rates turn higher than long-term interest rates; an ominous indication of pessimism—as investors shun short-term treasuries (forcing their yields higher) and buy low-yielding longer-term treasuries. Only one who sees real near-term danger would buy a low-yielding long-term instrument over a comparably or higher-yielding short-term instrument. Their bet is that the economy is about to tank, sending interest rates yet lower and sending the market value of their existing longer-term bonds higher. I placed arrows at past interest rate inversions. Notice the present healthy gap between  3-month and 10-year treasuries. 

And while the gap remains healthy, it has flattened a bit since last September. Those who would discount the possibility that this flattening might signal a weakening economy credit the fact that while U.S. yields are historically low, they remain higher than comparable government debt throughout the rest of the world. Thus inspiring investors to buy U.S. debt, keeping yields low...  Time will tell.

The white arrows point to times when the three-year treasury yield exceeded that of the ten-year (inversions). The red rectangles are recessions:

Recessions and inverted yield curves

As you can see below, the unemployment rate graph tends to take on a certain shape prior to recessions. So far so good:

Recessions and the unemployment rate

The spread between high yield bonds (debt issued by borrowers with less than perfect credit profiles) and treasury bonds can---when it expands---be a signal of stress in the system. That is, when investors require higher returns from questionable borrowers. Which happens when they see a higher risk of default. As you'll notice below, the yield spread has expanded of late. As I explained in mid-December, the energy sector has a little something to do with it. Nonetheless, this one deserves close monitoring:
Recessions and high yield credit spreads

The Index of Leading Economic Indicators (comprised of the average weekly hours worked by manufacturing workers, the average number of initial applications for unemployment insurance, the amount of manufacturers' new orders for consumer goods and materials, the speed of delivery of new merchandise to vendors from suppliers, the amount of new orders for capital goods unrelated to defense, the amount of new building permits for residential buildings, the S&P 500 stock index, the inflation-adjusted monetary supply (M2), the spread between long and short interest rates, and consumer sentiment) looks good:


I'll simply copy and paste my comments on the Recession Probabilities Index from last September. The chart below is just barely more current than the one I featured back then. The Fed hasn't updated it since 10/1. The National Bureau of Economic Research (NBER) is the official arbiter of recessions. It is common thought that four indicators weigh the heaviest on their analysis (although they make reference to a number of others on their website): industrial production, real personal income (excluding transfer payments), nonfarm payrolls and real retail sales. University of Oregon economics professor Jeremy Piger maintains real time recession probabilities by melding these four indicators into a Recession Probabilities Index. Notice (click to enlarge) the upward move in the index that preceded each of the past seven recessions, and notice its current position (no worries for now): 

Recession Probability Index

The St. Louis Fed Financial Stress Index (as of last Friday), while still comfortably below zero (low stress), has ticked up a bit since I last reported it to you in September. Here's my description followed by the current chart: The St. Louis Fed publishes what it calls the Financial Stress Index. It aggregates seven interest rate series, six yield spreads and five other indicators. It is understood that these data series, each capturing an aspect of financial stress, move together as the level of financial stress in the economy changes. The average value for the index is zero (beginning in 1993), which represents normal financial market stress. A move in the index below zero denotes below-average stress, while a move above zero denotes above-average financial market stress.

St. Louis Fed Financial Stress Index

I saved the best, because it speaks to today's ill-founded fear of low oil prices, for last. Notice how recessions tend to be preceded by higher, not lower, oil prices. Now that makes perfect sense to you, right? And notice how oil prices tend to decline during recessions, then (often) bottom sometime past the mid-recession point. At its lowest point this week, oil got all the way down to the March 2009 low. You may recall that March 2009 marked the beginning of what has become a nearly 6-year bull market in stocks.

Some see the plunge in oil prices as a harbinger of bad economic things to come. Thing is, that's just not how it works: Ask yourself this simple question; wouldn't the huge savings at the pump for literally every car driver in the country produce an economic stimulus that would more than offset the hit to the U.S. oil industry? Uh, yes! It would. And, make no mistake, while the U.S. has indeed become a huge oil producer, we are still net importers. Which means the U.S. consumer is presently benefiting from a redistribution of Middle-East wealth. Please, don't complain!

Recessions and oil prices

Just one more chart. This one's for those who fear that U.S. stock market valuations just have to be getting to dangerous levels. While it is indeed higher than it was at, say, the start of 2013, the price to earnings ratio (p/e) of the S&P 500 index, by itself, doesn't frighten me in the current inflation environment.

In the chart below I show the trailing 12-month p/e for the S&P 500 and the U.S. Consumer Price Index (CPI) all the way back to the mid-1950s. I placed parallel lines at 15 and 5. As you can see, p/es (white line) tend to remain above 15 during times when inflation (red line) is running below 5% (not even close currently).

Could it be that stocks are presently overvalued, as many suggest, even while inflation remains below 5%. Absolutely! It's just that, historically-speaking, a short/mid-term investor, with a little awareness, probably wouldn't panic just yet. Of course long-term, well-balanced, investors never panic...


Now, all that said, and shown, please, do not take this as my prediction that we've nothing but blue skies to come. It's been my experience over the past 30-years that even when all the indicators line up positively the market can cut through charts like these like a knife through butter. 

In fact, I recently offered up a detailed chart, along with some data that suggested that today's market could suffer a greater than your garden variety recession once the Fed gets off the dime and begins "normalizing" interest rates. Which remains, in my view, a likely scenario. 

So, expect volatility, lots and lots of it in 2015 as short-term traders drive each other crazy.

I'll say it again:
The unpredictability of markets, while unnerving to some, forever offers opportunity for the disciplined investor. In fact, long-term investment success is indeed all about discipline. Investment mistakes are typically emotionally-driven. Fear can drive an investor out of equities long before his/her financial plan would have called for. Typically, and ironically, the times of extreme panic have tended to be extreme buying opportunities. Conversely, greed can inspire an investor to overweight—relative to his/her time horizon and tolerance for risk—a given sector, or equities in general. Typically, and ironically, times of investor euphoria (think tech in the late 90s and real estate in the mid 00s) have tended to be ideal times to rebalance out of equities.

Maintaining an asset allocation/rebalancing strategy keeps one from succumbing to the herd mentality. And, as we’ve discovered, following the herd is generally not your recipe for long-term success—think tech in the late 90s (irrational exuberance), the subsequent market bottom in March 2003 (extreme panic), and real estate in the mid 00s (irrational exuberance), and the subsequent market bottom of March 2009 (extreme panic). I suspect the holders of long-dated bonds have yet to learn that painful lesson.

The Bottom Line – economically, and societally, speaking

While there’s plenty in terms of geo-political risk to concern ourselves with at present, the future holds as much promise today as it has at any time in history. Yes, mistakes, particularly mistakes of policy, will be made. And yes, such mistakes will deliver hurdles and setbacks in the years to come. And yet future generations will witness the advancement of the human condition in ways we can’t even begin to imagine. The ultimate pace of that advancement will be determined by the extent to which we possess the freedom to pursue our individual objectives, and the freedom to conduct business in the global marketplace going forward.

Near-term, I remain cautious. Long-term—bumpy roads notwithstanding—I remain wildly optimistic. That (long-term wild optimism) said, your portfolio must, at all times, reflect your time horizon and your temperament.

Per the following highlights from this week's economic journal, the U.S economy, on balance, remains in expansion mode:

JANUARY 5, 2015

DECEMBER AUTO SALES softened 1.7%. Although, overall, still a strong and expansionary number---coming off of an extremely strong November.

THE GALLUP CONSUMER SPENDING MEASURE FOR DECEMBER had Americans spending $98 per day. This is at the upper end of the number since 2008. However, it's not much of a bump off of November's $95/day, or the $96/day in December 2013. While positive, this particular measure does not support my position that the retail numbers will come in substantially greater than we've seen in recent years.

JANUARY 6, 2015

GALLUP'S US ECONOMIC CONFIDENCE INDEX continues to improve, to -5, from -8 prior. To put this into perspective, the number was -65 in late 2008...

THE JOHNSON REDBOOK RETAIL REPORT showed sales slowing last week to a year over year rate of 4.3%, from 5.4% the week prior.

MARKIT'S SERVICES PMI slowed in December to 53.3, which was close enough to the consensus estimate of 53.6. While growth in new business, output and employment slowed---which bears close watching going forward---the number is still comfortably in expansion mode (above 50)...

FACTORY ORDERS declined once again at a -.7% clip. Which was the same as last month and below the consensus estimate of -.6%. Nondefense capital goods were a minor bright spot, up just .1%... Overall, another weak report. The slowing in shipments and new orders hasn't resulted in a build in inventories, which is good.. Plus, unfilled orders remains steady...

THE ISM NON-MFG (SERVICES) INDEX slowed to 56.2 from November's 59.3. However, the November number was unusually strong. Despite the slowing pace (business activity and new orders) from November, the employment component is registering continued strength, which denotes optimism... Plus, the overall read, is still very solidly in expansion territory.  Here's Econoday's commentary:
December growth in ISM's non-manufacturing sample, at 56.2, slowed substantially from, however, November's unusually strong 59.3.

Details show particular slowing in business activity, down 7.2 points to 57.2, followed by slowing in new orders, down 2.5 points to 58.9. A plus is respectable strength for employment, down only 7 tenths to 56.0. Prices paid, reflecting lower fuel costs, fell 4.9 points to 49.5 for the first sub-50 reading since September 2009.

Despite the slowing, signals from this report are still very healthy, underscored by the breadth of strength among individual industries with 12 of 18 reporting monthly growth. The two leading industries for December –- retail and accommodation & food services –- point specifically to consumer strength during the holidays. Other readings include a gain for construction and monthly contraction for mining.

API WEEKLY CRUDE INVENTORIES declined by 4 million barrels, which would be bullish for the price. However, as follows, distillate and gasoline inventories grew.

API WEEKLY DISTILLATES STOCKS grew 9.1 million barrels.

API WEEKLY GASOLINE STOCKS grew 6.9 million barrels.

JANUARY 7, 2014

MORTGAGE PURCHASE APPLICATIONS fell noticeably, down 5%, during the two weeks ending January 2 (two-week report, vs the usual one-week, due to holiday). This doesn't square well with what the mortgage rates, the jobs picture and consumer optimism of late would be signalling. Refinances were down 12% for the period. This will be interesting to track going forward. The aforementioned indicators would suggest much better results going forward...

THE ADP EMPLOYMENT REPORT FOR DECEMBER came in at a strong 241,000... And November was revised higher by 19,000, to 227,000. This number supports what I'm seeing in the various employer surveys, etc...

THE GALLUP US JOB CREATION INDEX, a survey of 15,000 full and part-time workers asking what their employers are up to, came in at 27, which is nicely higher than January's number, 19, but basically flat, save for a spike to 30 in September, during the second half of the year. While positive on the year, this one's flatness runs counter to what I'm seeing in the surveys and in the actual jobs numbers of late.

THE US TRADE DEFICIT, a sadly confused (by the masses and too many economists) statistic, shows a shrinkage that is no doubt due primarily to the lower pricing of oil imports. This result will help the Q4 GDP number.

Like Tuesday's API report, THE EIA PETROLEUM STATUS REPORT showed a draw down in crude last week, and a big build in gasoline and distillates: -3.1 million barrels, +8.1 million barrels and 11.2 million barrels respectively.

THE FOMC MINUTES confirmed the notion that this Fed, while acknowledging that it'll likely happen this year, is in no hurry to raise interest rates. Stocks appeared to rally big time on the news...

JANUARY 8, 2014

CHAIN STORE SALES justified my optimism over this year's retail season, showing an annual increase of 4.9%. Your typical expansion range is 3.5%+...

THE CHALLENGER JOB-CUT REPORT came in impressively, for the full year, with 483,171---the lowest total since 1997. In December, layoffs totaled 32,649 vs 35,940 in November and 30,623 last December...

WEEKLY JOBLESS CLAIMS declined by 4,000 last week to 294,000. The 4-week average is now at 290,500. Continuing claims for the Dec. 27 week rose 101,000 to 2.452 million, however the 4-week average fell 17,000 to 2.397 million. The unemployment rate for insured workers remains at 1.8%.

THE BLOOMBERG CONSUMER COMFORT INDEX continues to show real optimism. Coming in at 43.6 vs the prior week's 42.7. The advance was led by increased optimism over the economy and personal finances. Bloomberg believes the higher sentiment in 8 out of the last 10 weeks will likely support gains in household spending, thus helping drive the U.S. expansion.

NAT GAS INVENTORIES declined by 131 bcf according to the EIA... Total inventory: 3,089 bcf.

THE FED BALANCE SHEET grew by $1.9 billion last week after declining by $11.8 billion the week before. Total assets stand at $4.5 trillion.

M2 MONEY SUPPLY grew by $12.0 billion the week 12/29 week. M2 consists of savings deposits, small time deposits and retail money market mutual funds.

JANUARY 9, 2015

THE DECEMBER EMPLOYMENT SITUATION REPORT showed job creation of 252,000, which is a strong number and confirms what I'm seeing in both the consumer and employer surveys. Plus, October and November were revised by a net 50,000 higher. The unemployment dropped to 5.6%. Average weekly hours, as expected, were unchanged at 34.6. Construction jobs, which speaks loudly to my optimism over the home builders going forward, advanced by 67,000, after growing by 20,000 the month before. Manufacturing employment rose by 17,000, after rising 29,000 in November.

All that sounds great, however, much to my, as well as the consensus's, surprise, average hourly earnings declined by .2%. Which makes for a mixed report.

In terms of wages: they're always late to join an expansion. The labor market has to tighten first, then, when the available worker pool shrinks, employers are forced to compete on price... I'm optimistic on wage growth in 2015...

WHOLESALE INVENTORIES jumped by .8% in November, vs .4% in October and a consensus estimate of .3%. While this helps the GDP number for Q4, and some might say denotes optimism, it's not good news in my view. Rising inventories generally result in slower production during the ensuing weeks, maybe months. At 1.21, the inventory to sales ratio is not horrible, it suggests an increasing trend of late (1.19 in September, 1.20 in October)... My best guess, based on the overall optimism displayed in the surveys, is that this data will improve in the coming months...


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