August 16, 2010
A Fragile Economic Outlook Continues
Last week, the markets responded to further evidence of a slowing in economic activity, including a further deterioration in new claims for unemployment. Given that the sharpest deterioration in leading economic measures such as our Recession Warning Composite and the ECRI weekly leading index growth rate occurred in the May-June period, we will remain concerned about deterioration in employment conditions through the October-November time frame, based on typical lags in the data. Weakness in the ISM data typically follows leading economic measures more quickly, so the August and September readings will be important data points. Clearly, we are in the window where the market would be expected to be very sensitive to changes in the economic outlook, which is largely what we observed last week in both stocks and bonds.
Among modest positive signs, the growth rate of the ECRI Weekly Leading Index ticked up slightly to a -9.3% reading, but still at a level that would be consistent with an ISM Purchasing Managers Index in the low 40's by October or November. While the ECRI has expressed increasing economic concerns, it has not yet warned conclusively of a double dip. This is not a heated disagreement, simply a difference in analysis and statistical interpretation. For our part, we view the recent few quarters of economic expansion as the result of enormous fiscal and monetary stimulus, without much "intrinsic" private sector expansion at all. Now that inventories are replenished and the fiscal stimulus is tapering off, my impression is that the underlying and still uncorrected fragility in the economy is likely to reassert itself for a time.
I should note that the ECRI recently published a piece reflecting frustration at the misinterpretation of its data by a number of analysts. Since we have a lot of respect for ECRI, I checked with Lakshman Achuthan to make sure we hadn't contributed to that. Lakshman assured us "We don't have any problem with your work. In our article, we were trying to address the overly simplistic analysis done by a number of commentators ... and that wasn't you. Basically, the amount of slanted or confused commentary was becoming so great that we saw a growing risk in terms of permanent reputational damage to the WLI."
From our standpoint, the best interpretation of the ECRI data is that we've observed clear indications of a likely slowdown in economic activity, though there remains some uncertainty as to whether it will be sufficiently deep to define a double dip or an extension of an existing recession. The WLI has a very strong correlation with ISM data with a lead time of about 13 weeks, and significant though less powerful correlation with new unemployment claims with a lead time of about 23 weeks. For that reason, the next few months will be an important window for the U.S. economy. The stock market is currently priced in a manner that largely requires the economy to avoid such a soft patch, and the likelihood of avoiding a downturn entirely is extremely low on a statistical basis. There is enough fragility in the housing and employment markets that even a moderate period of economic weakness would likely have very pronounced effects on variables such as confidence, credit spreads, mortgage delinquencies, and other sentiment-related measures. Stock prices seem unlikely to be excluded from that group.
To put some numbers on this, since 1967, when the growth rate of the ECRI Weekly Leading Index has been negative and falling (i.e. no more than 10 points from its 6-month low), the 4-week average of new claims for unemployment has been above its 5-year average, and the S&P 500 has been - based on our standard estimation methodology - priced to deliver a 10-year average annual total return of anything less than 9% (our current projection is closer to 6%), the S&P 500 has lost value at a -17.3% annual rate. Interestingly, the prevailing trend of the market has not mattered in this environment. For example, the average loss has been nearly the same regardless of whether the S&P 500 was above or below its 50-day moving average, though returns have actually been somewhat worse if the S&P 500 was above its 200-day moving average at the time. Suffice it to say that the present combination of valuations and economic indications is not constructive.
As of last week, the Market Climate for stocks was characterized by rich valuations, unfavorable economic pressures, and elevated though not extreme bullish sentiment (the Investors Intelligence figures are 41.7% bulls vs. 27.5% bears). We also observed an abrupt and somewhat surprising amount of technical damage last week. That damage is not quite to the level that would create urgent downside concerns, but as I noted last week, the deterioration could be very abrupt if the economic data continue to come in weaker than expected. We are fully hedged in the Strategic Growth Fund. Given the repeated tendency for investors to "buy the dips" on the false perception that stocks are cheap (primarily on the "forward operating earnings" argument that we've analyzed in recent weeks), we may see a "fast, furious, prone-to-failure" advance to clear the short-term oversold conditions we developed last week. Still, caution is important here, since we're in a set of conditions where one or two hard down days can wipe out weeks of choppy upside progress.
In bonds, the Market Climate remained characterized last week by unfavorable yield levels and favorable yield pressures. Over the near term, perceptions of economic risk are clearly dominant, and given the tendency for the Treasury yield curve to flatten during periods of economic weakness, we may see long-term Treasury yields pressed even lower for a while. At the same time, however, increased risk perceptions could hit corporate bonds very hard even in a softening economic environment. While corporate cash levels may very well reduce liquidity risk for companies that would otherwise need to raise funds in a tight credit market, investors should not ignore that the overall debt burden of U.S. corporations is higher than it has ever been.
For companies with low earnings cyclicality, cash provides a clearly better margin of safety than for companies that are prone to earnings losses during periods of economic weakness. Just as dividends have to be evaluated in relation to the earnings available to cover those dividends, and the stability of those earnings, investors wishing to hold corporate bonds for additional "pickup" in yield should pay close attention to earnings stability, cash reserves, and overall debt burdens. We would emphatically avoid the debt of financials and cyclicals that are prone to massive "extraordinary" losses that can quickly wipe out available liquidity.
New from Bill Hester: The Paradox of the Zero Bound
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